BMW: One Of The Cheapest European Companies

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About: Bayerische Motoren Werke Aktiengesellschaft (BMWYY)
by: Mario Glogović, CFA
Summary

Discounted cash flow valuation shows an upside potential of more than 35%.

BMW is transforming its production and distribution, as it did successfully numerous times throughout its history.

The product strategy, which is in place, will keep the company at the top of the premium sector.

BMW is priced as one of the cheapest large-cap European companies, as market participants do not fully appreciate the long-term product development plan.

Despite the trade tensions, during the first quarter, BMW in China achieved a growth of 10.2%.

For car manufacturers, there are a lot of threats, starting from trade wars and tariffs, to regulation and technology challenges. But through its more than 100 years of history, BMW (OTCPK:BMWYY) successfully survived two world wars and a myriad of regulation and technology disruptions.

Currently, the question is, is the situation so dangerous that BMW should trade as one of the cheapest European companies? Are the problems so big that the company should be almost 50% below the prices achieved three years ago?

In my opinion, answers to these questions are negative, and according to this analysis, BMW offers plenty of upside potential. Although some companies from this industry will be heavily hit and deserve a big discount, BMW is transforming its production and distribution, as it did successfully numerous times throughout its history. Additionally, it has a product strategy in place that will keep the company at the top of the premium sector.

In investing, what is comfortable is rarely profitable, so it frequently pays to be a contrarian and value investor that buys out of favor, forgotten stocks that are trading at the deep discount to the overall market.

BMW is currently neglected and overlooked and is priced as one of the cheapest European large-cap companies, which is why it is a really good candidate for a deep value investing style that in the long run statistically leads to above-average returns.

Light Vehicles Market Development

Due to the harsh market conditions, during the first four months, nine out of the twelve largest automotive producers experienced sales decreases, while GM, Ford, and French PSA saw double-digit drops. With the 2% unit increase, BMW was among three companies that achieved higher sales and was slightly behind Honda that made the best result with the 3% increase.

Daimler, which is BMW's closest competitor, during the same period, experienced a sales decrease of 3.5%. BMW is closing the sales gap between its fiercest competitor, and if this sales development continues, it will challenge Daimler's status as the world's largest premium market manufacturer.

Source

As a result of numerous headwinds, during this year, the car manufacturing industry will experience negative sales. However, according to the global light vehicle production forecast, in the next five years, worldwide production should grow by an average rate of 2.9%.

Additionally, the forecast is that the developed markets, including the US, will be laggards. According to Goldman Sachs' projections, as income per capita will grow, emerging economies will account for an ever-increasing share of the global new automotive purchases.

Source: Goldman Sachs

Trade Wars

Despite the trade tensions and problems, during the first quarter, BMW in China achieved a growth of 10.2%, which confirmed that the company is successfully executing its planned strategy.

Source

During the last year, China communicated its decision that it will abolish the longstanding regulation on foreign ownership for car manufacturers. Authorities promised that the law would gradually phase out all restrictions on foreign ownership in the automobile industry. The first phase included electrical vehicle manufacturers in 2018, the second phase will consist of commercial vehicle producers in 2020, and the last stage will be in 2022 for passenger vehicle companies.

Under the current law, foreign car manufacturers that want to produce or sell cars in China have to establish an equal share joint venture with local companies. As the Chinese market is the world's biggest, success in it is paramount for many car makers, and for BMW, this change could have a significant impact on revenues and profits.

With this move, Chinese authorities want to increases local investments and shift production from North America to China. Following this change, BMW was the first foreign producer that announced its move to gain control of its Chinese joint venture. After the deal, BMW will own 75% of Brilliance China Automotive Holdings Ltd and the agreement that will be finalized in 2022 when rules change.

Alongside the deal, BMW will invest in new and existing plant facilities in Shenyang, and from 2021 production capacity will be increased to 650,000 per year. For comparison, during 2018 this joint venture produced 400,000.

Additional to expanding existing capacity with the current partner, BMW formed another joint venture for the production of electric Minis, which will from 2021 be able to produce 160,000 cars annually.

During the last year, China was by far the most important market, and with 640,000 units sold (up 7.7% compared to 2017), it had a share of 25.7%. If the growth from the last year will continue in the following years, the total number of sold vehicles in 2019 will be around 690,000, in 2020 around 740,000, and 2021 around 800,000.

As in 2021, the production capacity of both Chinese joint ventures will be 810,000, the production and projected sales will be more or less in line, and the local market will not be dependent on imports, which are now primarily done from the US.

It will take approximately a year and a half for Chinese distribution to become independent, so until then, the US-China trade war could influence BMW's revenues and profits.

In that regard, the direct influence of the US-China trade war could only be temporary and not long lasting. Nevertheless, prolonged uncertainty is definitively not in the interest of BMW as it could have an impact on the growth of the Chinese automotive market.

Source

The US-EU trade war could be an additional issue, but for now, Trump delayed its tariffs decision on European Union automotive products until the end of this year. Nevertheless, even if the US imposes tariffs on EU imported cars, BMW should not be too exposed because the annual US production capacity is around 450,000 units, and unit sales in 2018 in North America were 457,700 units.

Source

While one part of cars manufactured in the US was imported to China, the Chinese market should become self-sufficient, which will free up US production to be used almost exclusively for North American sales. Essentially, the US-EU trade war could have a mid-term impact, but in the next two to three years, most distribution problems should be solved.

Product Development

From 2020, the new European Union CO2 law will start, which will necessitate that the full fleet of sold vehicles on average comply with 95 g/km of CO2. Nevertheless, there will be a one-year adjustment period, requiring 95 percent of new vehicles to comply with the law in 2020 and 100 percent from the end of 2020 onward. Essentially, the 95 g/km target, applies from 2021 on.

As an answer for stricter regulation and technology disruption, until 2025, BMW plans to introduce 25 electrified models, out of which 12 will be fully electric. Additionally, from 2021 all platforms will fit different powertrain versions, from combustion engines to hybrid models and at the end fully electric vehicles.

Source

Other than its EV offensive, BMW has a focus on the growth of the X family, including Rolls-Royce Cullinan, which is the first full-sized luxury SUV produced by Rolls-Royce Motor Cars. With such product mix, BMW positioned itself to benefit from SUV and EV growth, which should foster long-term revenue and profitability growth.

Source

Discounted Cash Flow Valuation

As the bond market is once again at record highs, the German 30-year government yield fell to 0.32%, which is only 0.03% above the lowest point in history recorded during 2016. Trade wars between the US on one side, and China, Mexico, and the European Union on the other sparked new recession fears and ignited flight to safety, which pushed down the safe haven bond yields.

Source

Falling German Government bond yields are definitively positive for BMW. With other things unchanged, this leads to lower financing costs for German companies, and subsequently, BMW can through its Financial Services division, offer lower financing costs to its customers.

As BMW noted in its first-quarter report, 50.0% of new BMW Group vehicles were either leased or financed by the Financial Services segment, up from 47.3% managed during the same quarter of the last year.

Although positive for the company, Eurozone's interest rates that were artificially driven down by the European Central Bank's massive quantitative easing program distort projected equity valuations. As the cost of equity and a pre-tax cost of debt for BMW are too low, according to the classical economic theory, the calculated discount rate (WACC) is only 7.63%.

I believe that the bond market is significantly distorted and that the current discount rate is a product of ECB's too big market intervention. Because of this, I use a much higher discount rate of 11%. Although this is an arbitrary figure, I believe it better represents BMW and the current equity market environment.

Beta source; Equity Risk Premium source

Besides the 11% discount rate, I used a perpetual growth rate of 3%, and a tax rate of 27%, which was BMW's average for the last five years. Although from the beginning of the previous year, the US statutory corporate tax rate was decreased from 35% to 21%, which should reduce the average tax rate for the next five years, I stick with 27% as there is always the risk that some of the countries that BMW operates in will increase taxes.

Although revenues for the first quarter were flat, due to the possible trade war and tariff escalation I have modeled 5% lower revenues, coupled with a lower EBITDA margin.

As on 5 April 2019, the BMW Group has reported the EU Commission has ongoing antitrust proceedings against the company; results for the first quarter include the provision of €1.4 billion. The proceeding charge is included in this DCF as well, and consequently, the EBIT of this year is projected to be around 30% below the last year's figure.

Interest-bearing debt includes debt from the Financial Services part of the company, which serves as a bank for car and motorcycle units. On the other hand, cash and equivalents include Financial Services' leased products and receivables from sales financing.

Although I have accounted for the trade war escalation and a significant decrease in profitability, the upside potential is still significant and reveals an undervaluation of more than 35%. According to this DCF valuation, the projected price is €85.48 ($96.80).

Recap

Despite the significant problems that currently plague the automotive industry, BMW has a solution for them and has developed a plan with a focus on fully electric and hybrid vehicles. In a highly profitable premium SUV segment, it has positioned itself as a leader, and this will be fortified by significant electric options that will follow in the next two years.

At the current level, the market expects the too pessimistic outlook, and prices this company as one of the cheapest large-cap European stocks. It seems that market participants do not fully appreciate the long-term product development plan, and production and distribution changes, which coupled with the significant undervaluation offers an excellent entry point with a high reward to risk ratio.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BMWYY over 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.