Sunday, 6 August 2017

BMW & bargains in plain sight

If the bears are to be believed, we are living in a world of overvalued global markets inflated by excessive central bank stimulus, that offer investors the torturous combination of scant opportunity and substantial systemic risk. I do not see this narrative in my portfolio. Sure, there are parts of global markets that are expensive - notably yield-proxies, and parts of the tech industry. However, there are still plenty of bargains in other parts of the market hiding in plain sight.

An example right now are the shares of BMW Preferred. BMW is hardly an obscure company nobody has ever heard of. And yet the stock is startlingly cheap - particularly the prefs. BMW has 602m ordinary shares outstanding at 55m preferred shares. The latter have substantially identical economic rights to the ordinary shares, but lack voting rights. They trade at €70, or an approximate 12.5% discount to the common (the ords trade at about 80).

As a small-time punter, any voting rights I acquire count for little, and the prefs have more than sufficient liquidity for an investor of my size, so the liquidity discount is not at issue. I therefore own the prefs. At the current pref share price of 70, BMW's market capitalization (all 657m shares of both classes) is 45bn. As I hope to demonstrate, this appears remarkably cheap.  In the short term, regulatory & EU penalty/fine risk is high, but fundamentally, the stock looks cheap enough to endure almost any degree of feasible penalties.

The auto narrative is bad

At the moment the market does not like auto stocks, because the narrative is poor and goes something like this: Cyclically, the US auto cycle looks to be topping out, and China is probably not too far behind as well. In addition, structurally, the world is heading towards a future of fully electric vehicles (FEVs) replacing internal-combustion engine (ICE) vehicles. This is likely to disrupt traditional automakers, it is argued, and will require them to compete with a range of new innovative market entrants. This includes - most obviously - Tesla, but also potentially other Silicon Valley behemoths like Google and Apple, which may seek to enter the fray as well.

In addition, a move to fully-autonomous vehicles is on the horizon, which could fundamentally change the relationship we have with our cars. The world may eventually trend away from private car ownership towards a TaaS ('transportation as a service') future where autonomous ride-hailing fleets provision our mobility needs. In theory, this could result in a considerable shrinkage in the size of requisite automotive fleet (as utilization rates rise), as well as industry commodification, as vehicle sales transition to large standardized fleet sales rather than differentiated individual sales.

Thirdly, the much maligned millennial generation apparently do not care about car ownership - preferring to use Uber and live in inner-city areas close to work to avoid the need to commute - and importantly, do not view cars as a status symbol in the manner their parents' generation did. Showing off experiences on Facebook is in, and showing off luxury goods is out. This also threatens to commodify the industry long term and reduce luxury automobile brand rents.

Fourthly, certain German automakers have been caught cheating on diesel-emissions testing in the past, and complying with EU regulators diesel emissions standards economically without cheating could prove difficult. Ergo, the German automakers - which have bet big on diesel technology -  are stuffed. In addition, fines and vehicle defect recalls are a perennial industry risk.

Lastly, the automobile industry is historically not just cyclical, but also capital intensive and vigorously competitive, which has resulted in the industry generally failing to earn its cost of capital over a full economic cycle. With all of the above long term risks, why bother?

For those who care to look no further, there appears to be 'no reason to be there'.

Forget the narrative for a moment, and look at the numbers

Before addressing the merits of the bearish narrative, it is worth noting that in my experience, when in conflict, it is better to bet on what the objective data is telling you, rather than the popular narrative.

As is often the case in all manner of human political and societal affairs, the popular narrative is often subjectively biased; laden with agenda and wishful thinking; and overly simplified. The stock market is no different. Nuanced thinking is hard and time consuming. Binary thinking condensed into soundbites is easier to digest and is more immediately actionable. The advantage of starting with the data is that - provided the data is reliably assembled and accurately interpreted - it is generally more objective and free of such biases. It's a good starting point.

If one looks at BMW objectively, what they will find is a company selling vehicles in record numbers, and booking record sales and profits, because they keep producing and selling cars that people want to buy. People want FEVs not ICEs? Not in the numbers. People don't care about the BMW brand any more? Not in the numbers. The auto industry is unprofitable and competitive? Not in the numbers: BMW's automotive EBIT margin is pushing 10%, and their return on invested capital has been consistently above 20%. The data also paints a picture of global economic growth being relatively solid at present as well, despite the preponderance of doom-merchants.

Furthermore, when analyzing companies I always start with the balance sheet - a much neglected financial statement by the earnings-obsessed markets. If one cares look, it can be easily observed that the company has cash, liquid investments, and on-balance-sheet finance receivables/lease assets (which relate to their substantial in-house financing division), net of all company and financing subsidiary debt and group pension obligations, of 35bn - an incredible 78% of the company's market capitalization (at the prefs price).

The company also has a 50:50 Chinese JV in partnership with the listed Brilliance China Automotive (1114  HK), which, incidentally, has risen 137% over the past 12mths. The book value of this JV is about €3bn (BMW's share), but the market capitalization of Brilliance is now HK$105bn, or 9.2bn, or about 3x book. If BMW's 50% share is similarly valued 9bn, this would take BMW's valuation to 44bn inclusive of the above net financial position, before placing any value on the company's global auto operations excluding China.

Those automotive operations, by the way, made a record €4.3bn in operating profit (EBIT) in 1H17 (€4.1bn for automobiles and €0.2bn for motorbikes). Net of taxes, annual automotive earnings are likely to approach €6.0bn this year. Inclusive of earnings from the companies JVs and financing subsidiaries, group earnings are likely to exceed €7.0bn, and place the stock on a PE of about 6x (at the prefs price).

As can be seen, even if the popular narrative is right about the long term impending doom of the conventional auto industry, the stock still looks to be a buy to me.

Why the narrative may be wrong

Furthermore, there are many reasons why the popular narrative outlined earlier may prove either too pessimistic or even flat wrong. Note that I say may. That's enough for the stock to be compelling, as one's downside is covered by a very conservative valuation as discussed. Optionality creates value, and if the market ever favorably reappraises the outlook, a lot of money could be made.

Firstly, with respect to the (likely) the coming transition towards electric vehicles, it is important to bear in mind that FEVs are much less of a disruption to the traditional auto industry than, say, digital cameras were to Kodak. Traditional auto companies are quite capable of transitioning to manufacturing FEVs - indeed most are already capable of mass-producing them, and are not doing so primarily because consumer demand still remains relatively limited (interestingly, BMW sold 45k fully-electric and hybrid-electric vehicles in 1H17 - roughly the same number as Tesla; unlike Telsa, however, BMW also sold 1.2m highly profitable conventional vehicles during 1H17).

BMW has noted that by 2019-20, it is aiming to have its platforms capable of producing ICE, hybrid, and FEVs on the same production line, which will grant the company flexibility to rapidly switch between alternative powertrains in response to shifts in consumer demand (which can be impacted by government subsidies and oil prices). This will place the company at a medium term strategic advantage to companies like Tesla who can only produce FEVs (and will only produce FEVs, given that accelerating the adoption of FEVs is the company's mission). In short, FEVs are an evolutionary rather than revolutionary automotive technology platform (for the car industry) that existing auto companies will quickly adopt, rather than be put out of business by.

In addition, and very importantly, the automotive industry has long been intensely competitive. This is very important, because the companies that are most vulnerable to disruption are hitherto lazy monopolies. Auto companies are not lazy and inefficient - they cannot afford to be because competition is merciless. Auto companies are already battle hardened, and they will be quick to copy and adopt new and successful innovations companies such as Tesla pioneer. Many many companies are investing in autonomous vehicle software as well, so such software should be easy to license (BMW is spending heavily on in-house R&D - more than 4% of sales - as well).

Silicon Valley is good at writing code, but it has no special advantages when it comes to mass-producing automobiles efficiently and profitably, and in my opinion it is more likely to be large auto companies with decades of experience designing, mass-producing, marketing, and distributing automobiles, with established brands, that are likely to win in FEVs, not new Silicon Valley market entrants (the exception is Tesla which I think will likely do reasonably well long term, although I have no interest in owning Tesla stock at current prices).

In addition, the automobile industry is not a winner-takes-all industry. People have different tastes in cars as well as different needs and uses for them (style, comfort, prestige, performance, people-mover, safety, haulage capacity, etc), and so there is room in the market for different brands. For the foreseeable future, automobile brands and styling will continue to matter to many car buyers.

What about the move to full autonomy and ride-sharing? There appears little doubt that vehicles will eventually become fully autonomous, but the question of when is difficult to answer. It seems likely to me that there will be orders of magnitude leaps in complexity associated with moving from 90% reliability, to 99%, to 99.9%, and then 99.99%, etc. No doubt we will eventually get there, but partial-autotonomy/assisted driving seems likely to be with us for a considerable period before complete hands-off-the-wheel autonomy capable of handling all driving situations and road and weather conditions is achieved.

It seems like a 5-10yrs technical project at a minimum to me, for 99.9999% reliability to be achieved, and it could well be considerably longer. Then, regulatory approvals will be required (and regulators move a lot more slowly than technology), and then the existing auto fleet will have to be phased out and replaced - a task that in and of itself could take at least a decade. The transition certainly won't happen overnight, and in the meantime, companies like BMW are likely to continue to make a lot of money.

Furthermore, even in a full autonomy situation, it is not clear how much demand will decline. It is without doubt possible to envisage a future where households do not own a car but merely summon an autonomous Uber (or the future networked equivalent) whenever they need to go from A to B. However, (1) peak demand will limit the extent to which fleets can be shared (for the foreseeable future, most people are likely get up and commute to and from work at about the same time, Monday to Friday), which will moderate the extent to which the fleet size can shrink via higher utilization; and (2) with the cost of personal mobility declining, it is likely that the quantity of personal mobility services consumed will rise (just as people fly more when it is more affordable).

This is also not to mention the considerable long term growth opportunity that exists in emerging markets where car ownership levels remain significantly below developed world averages. The US car & truck population is currently about 250m vehicles, or about 75 vehicles for every 100 head of population. By contrast, the global car population, on recent trends (I could only find data to 2014), looks likely to have climbed to 1.35bn by the end of 2016, or to about 18 vehicles per 100 head of population. This penetration gap is likely to continue slowly close over time.

The biggest short term risk is undeniably regulatory and any penalties associated with diesel emissions cheating or collusion that emerges. VW was ultimately fined more than €20bn, so the risks are far from negligible. I have few insights to add here, other than to say (1) the auto companies are vital to Germany's economy and employ a lot of people, so there is likely to be a limit to the extent to which German/EU regulators are prepared to harm them; (2) VW's 2014 experience is likely to have put Germany's other car companies on notice; (3) BMW has to date denied any wrongdoing; (4) last week's developments hint at the possibility of a sensible compromise solution; and most importantly (5) BMW's market price already provides a substantial margin of safety against adverse outcomes (although in the short term the share price will likely go down if outcomes are worse than expected). 

Longer term, the biggest risk to BMW is perhaps industry brand commodification if mobility moves primarily to ride-sharing that utilize homogenous fleets. However, in the meantime, the BMW brand continues to stand for prestige and class and will continue to, in my opinion, command a marketplace premium. The market is currently giving BMW little to no credit for this powerful brand value which is likely be enduring over at least the medium term, and whose existence is clearly evident in the company's ROIC metrics.

My positioning

I have owned BMW prefs since early this year at an acquisition price of about 70 (flat vs. its current trading level, but up about 15% after factoring in dividends and Euro appreciation). I recently took the opportunity to top-up after the stock weakened to 67 on renewed 'dieselgate' fears. BMW prefs have an average weighing of 1-2% weightings in portfolios I manage.

Comments welcome.


The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.