Mercedes-Benz: Wavering Performance And Limited Upside

Summary

• Mercedes-Benz is struggling with its EV transition and faces pressure from Tesla, who is slashing prices.
• On the other hand, Mercedes looks to be a market leader in Autonomous driving technology.
• Economic conditions and China removing its subsidies will likely contribute to slowing or declining sales in 2023.
• Mercedes' financial performance has been good, given the circumstances. COVID-19 has resulted in a sharp decline in demand, but Management has achieved improved profitability through efficiency gains.
• Although we see a marginal amount of upside, 6%, we consider the stock a sell due to the qualitative factors mentioned.

Karlos Garciapons/iStock Editorial via Getty Images

Mercedes-Benz

Mercedes-Benz (OTCPK:MBGAF) is a German automotive company. Mercedes develops and manufactures passenger cars in the premium and luxury segments, while also producing buses and EVs. Mercedes also provides ancillary services such as financing, parts, accessories, etc.

The current state of play

The automotive industry has gone through a significant change as EV (electric vehicle) automakers have emerged and gained a significant market share by aiming to quickly establish a technological edge over traditional ICE (Internal Combustion Engine) vehicle manufacturers. The transition has been slow for the ICE players as they cannot concentrate their resources in just one area. Their main focus still lies in the production of ICE vehicles, making it challenging for them to commit to a transition to EV. The financial performance of these two types of companies contrasts greatly, resulting in a vast difference in their valuations.

In recent years, we have observed an increase in the efforts of established automakers like Mercedes and Volkswagen (OTCPK:VWAGY) to embrace the transition to EVs. Both companies have divested non-core operations, such as Mercedes spinning off its truck and bus business, which has freed up capital to allocate more towards the shift to EVs.

Share price

Data by YCharts

Mercedes' share price can be defined as consistent, while clearly being underwhelming. The stock has spent the majority of the decade trading between $60-$90. The impressive uptick following the onset of the pandemic is a reflection of the unexpected robustness of demand, which looks to have tapered off.

Electric vehicles (EVs) and autonomous vehicles (AVs)

EVs

The growth of EVs has caused a fundamental shift in the automotive industry in the last decade, with EVs likely being the replacement for ICE-powered cars. Statista is forecasting a CAGR in unit sales of 17% into 2027, driven by regulation and consumers' desire to be more environmentally friendly.

Unit sales - EVs (Statista)

Mercedes has had no choice but to react to this trend, developing its own EVs, including the EQC and EQV. Further, the business is investing heavily in R&D in order to catch up to the leading companies in the industry, including Tesla (TSLA). Compared to the ICE-powered industry, technology is far more important and so the R&D delta is far more pronounced. The company has announced an expansion of its partnership with CATL, which includes the construction of a new production facility in Hungary. The new site will provide battery cells for its European production sites, with a total of eight facilities planned as part of its goal to be fully electric by 2030. These are ambitious plans but demonstrate Mercedes' commitment to the transition.

This is far from a perfect transition, however. According to Bloomberg analyst Michael Dean "German automakers have announced bold electrification targets and claim they are leading the transition, but they are not yet delivering". Their current level of market penetration is not sufficient enough to maintain dominance over the industry.

EV producers (Bloomberg)

The concern for Mercedes is that if it fails to secure a substantial share of the market now, it may fall behind once it cannot rely on its ICE vehicles. In China, the company made the mistake of underestimating the demand for its EQS, leading to a $33k price cut. Additionally, Tesla is currently reducing the cost of its vehicles, which could further challenge Mercedes to either match the price cut and sacrifice financial performance or surrender even more market share.

The long-held belief was that once the Germans came to the table, the EV specialists would quickly lose their technological advantage and the German's significant infrastructure would overwhelm the likes of Tesla. This has not happened. Instead, we saw a slow transition fail and has subsequently shifted into a fast one. Mercedes has a limited window of seven years to establish itself as a market leader in EV production, otherwise, they risk falling behind.

Autonomous vehicles

As if the EV transition is not complicated enough, Automakers must also commit resources to the AV movement.

Mercedes-Benz has been developing its autonomous vehicle technology, as this segment also threatens to disrupt the automotive industry. AVs can be incredibly beneficial in the passenger segment due to the ability to improve safety but could be far more lucrative in the transportation segment. Mercedes looks far better placed in this market compared to EVs.

Mercedes-Benz plans to launch a cutting-edge automated driving system in Nevada. This system, known as "SAE Level 3 conditionally automated driving," permits drivers to take their hands off the wheel and focus elsewhere, as long as they are prepared to take control if needed. This system is the first to market, with competitors such as Tesla and GM currently offering level 2 systems that require drivers to maintain full attention. Mercedes is positioning this system for commercialization, with the goal of gaining an early lead over its competitors.

We remain concerned with Mercedes' transition to EVs, as although they are making the correct investments, this is not translating into market share. Their AV technology is far more promising and could provide the EV segment with support by being an optional add-on.

The second-hand car market is posing problems

The growth of the secondary market for cars in the aftermath of the COVID-19 pandemic can primarily be attributed to two factors: the shortage of microchips and disruptions in primary car market production. The semiconductor chip shortage, which has been felt across multiple industries, has caused delays in the manufacturing of new vehicles. Additionally, the lockdowns and restrictions imposed during the pandemic have caused a slowdown in the production of new cars. As a result, consumers have been looking towards the secondary market to fulfill their transportation needs. This has had the effect of reducing supply in the second-hand market while increasing demand. Automakers are now looking to over-order microchips, in order to alleviate these supply chain issues.

Second-hand market price development (UK) (Autotrader)

The impact on automakers has been negative and can be best described as a missed opportunity. Demand remained robust post-COVID and offered producers a quick bounce back from lockdowns. This has not occurred as production levels could be increased, with Mercedes still down almost 20% from its pre-COVID revenue levels. With many consumers having purchased alternatives from other brands and in the secondary market, these sales will likely be lost until the next purchase cycle.

Tech and spending changes allow for further monetization

The rise of technology in cars is also having a significant impact on the automotive industry. Mercedes, along with other automakers, is investing heavily in developing technologies that will allow vehicles to communicate with one another and with infrastructure to create a safer, more efficient, and more convenient driving experience.

Recently, BMW generated media attention by announcing a monthly subscription service for its heated seats, priced at $18 per month. Without taking a stance on whether this is good or bad, automakers now have the ability to monetize various aspects of their vehicles more easily. Due to advancements in technology, there are numerous potential add-ons available, providing greater opportunities for upselling that were not present in the past. Heated seats are only the start.

Weakening demand is not a good sign

Demand for goods and services in the west has weakened in the last few quarters, driven by heightened inflation and rising interest rates. This cooling of demand has been partially orchestrated by raising rates, with the objective being to bring inflation under control. Our outlook for the coming 12 months is much of the same, as although inflation is coming down, it is not doing so at a rapid pace. We will likely require a few more quarters of heightened rates before inflation returns to a sustainable level.

The automotive industry is likely to face a challenging trading environment in the coming quarters, as consumers and businesses alike react to rising costs. It is difficult to see why a business, for example, would purchase a fleet of new vehicles with rates where they are. The same concept applies to consumers who are struggling with living costs, with consumer sentiment trending down for this reason. As a premium brand in the market, Mercedes will be impacted more greatly than others. Additionally, with supply-side issues impacting production costs, Mercedes may also face increased pressure on their margins.

For these reasons, our view is that the automotive industry will face headwinds in the coming few quarters. Consumers will focus on meeting their living costs and businesses will focus on shoring up their financials, neither of which will be rushing out to purchase a new vehicle. Mercedes may even be more greatly impacted by the fact the majority of its vehicles are in the premium segment, thus more elastic.

Financials

Production / deliveries

Q/Q Production and sales (Mercedes)

Mercedes has had a seemingly impressive rebound in sales, up over 15% Q/Q. However, a portion of this has been driven by Government purchase incentives in China and a lower basis for comparison in many markets in the prior periods. Looking at Mercedes' core markets, both the US and Europe saw flat sales numbers. This is an issue as China has recently pulled all subsidies for the purchase of EVs, which could result in declining demand from the region. This is especially likely if many predicted this to be a move from the Government, thus bringing forward purchases. Thus, although these numbers look impressive, our view is that weakening demand is already taking effect and Mercedes has slowed to a standstill.

P&L

Mercedes Financials (1/2) (TIkr Terminal)

The COVID-19 pandemic has significantly impacted Mercedes, resulting in revenue declining at a rate of 3% over the past 4 years.

Despite the decline in revenue, Mercedes has managed to maintain operational efficiency by reducing expenses at a faster rate. This has led to an increase in EBITDA by 11%.

The improvement in FCF yield can be attributed to the decrease in capital expenditures between the periods. However, it is likely that capex expenditure will increase in the coming periods, with this ratio likely peaking in the LTM period.

Balance Sheet

Mercedes Financials (2/2) (Tikr Terminal)

Management has successfully utilized this improving profitability and cash flow to both deleverage the business and reward shareholders through dividends.

Inventory turnover and CCC have both moved favorably, suggesting an improvement in production and better inventory management.

Holdings

Mercedes Benz Holdings (TIkr Terminal)

Mercedes has investments in several publicly traded companies, with Daimler Trucks, its spun-off entity, being the largest. Fluctuations in the value of these assets have the potential to affect earnings per share, which can become an issue during periods of weaker financial markets.

Mercedes' relative performance is attractive

Comp comparison (Tikr Terminal)

Mercedes performs comparably well against our chosen cohort of conventional automakers. The company's EBITDA margin is slightly higher than average, likely attributable to its premium focus, and it is expected to grow at a faster pace. The fluctuation of FCF yield among the companies is substantial, thus we assign less significance to Mercedes' superior performance in this area

Comp set valuation (Tikr Terminal)

Mercedes is marginally undervalued when compared to the cohort while paying a substantially higher dividend. We are of the view that dividends may need to fall in the coming period, due to weakening demand and capex commitments. Regardless, there is only marginal scope for upside.

Final thoughts

Mercedes has not fumbled its EV transition, but it is certainly floundering. The business has the 4th largest revenue of all automakers, yet is not close to this from an EV perspective. This presents a significant challenge in the coming years if the situation does not improve. However, their developments in autonomous vehicles (AVs) could be a saving grace, as the advanced technology can be integrated into their EVs. Alongside this, we are equally concerned about slowing demand and how this could further bite in China, following the subsidies being removed.

Overall, the qualitative aspects of the business do not currently appeal to us, and we view the stock as a sell.

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.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.