A Not So Ultimate Future for the Ultimate Driving Machine

May 3, 2019

Disrupted, cyclical and with poor profitability: Some very prominent Fund Managers invest in BMW- we don’t, and here’s why; 

  1. The automotive sector is facing both structural demographic and industry headwinds

  2. BMW itself is not an attractive investment

Given all the hype surrounding the trend towards autonomous and electric cars, surely it’s going to be a boon for the industry? So we took a trip to Germany; to investigate arguably the best and brightest in car manufacturing and technology. We engaged competitors, researchers, technology suppliers and others; and as always did our numbers. 

 

The greatest problems for the industry no matter the engine type

At Insync understanding the impact of global disruptions is at the core of our investment process. We consider it to be critical in today’s complex and fast changing world. Being large, historically successful and dominant means little anymore. The table below depicts a clear systemic and lasting demographic trend against new sales expansion

 

 

As Gen -Z’ers (the generation after Millennial's) become a larger part of the global workforce, understanding their consumer buying habits is going to be critical in picking the winners of tomorrow.Our previous article on Harley Davidson explains this trend in greater detail as they too face similar headwinds. 


A disturbing trend emerging for the automotive industry is that about a quarter of 16-year-olds in the United States had a driver’s license in 2017, a sharp decline from nearly half in 1983, according to an analysis of licensing data by transportation researcher Michael Sivak. 


Similar patterns are emerging across all developed nations and many emerging nations of consequence.


J.D. Power (a respected marketing research firm founded in 1968 in the USA) estimates that Gen-Z’ers will purchase about 120,000 fewer new vehicles this year alone compared with millennials in 2004, when they were the new generation of drivers (488,198 vehicles versus 607,329 then).

 

Key factors driving the decline led by Gen-Z’ers:

 

  • As they head into their 20's, more are moving to big cities with mass transit, where owning a car is neither necessary nor practical. This is occurring globally from the USA to Europe to Asia.

  • Many face growing substantial demands on their income for other items. Student-loan payments as an example, has student-loan debt soaring to $1.5 trillion (just in the USA), surpassing Americans’ credit-card and car-loan bills. Housing is getting more expensive globally and taking up more of their budget as traditional secure employment is also declining. All this, yet with record low interest rates, makes them justifiably more cautious about big-ticket purchases.

  • They value technology purchases in the same way as Baby Boomers and Gen X’ers did with cars at their age. “Same-Same but different!”

  • Car prices and affordability are increasingly a challenge and this may surprise many. The average price paid for a new vehicle in the United States was $32,544 in 2018, up from $25,490 a decade ago, according to J.D. Power. The average monthly payment on a new-car loan reached $535 a month last year, or more than 10% of the median household income (despite record low interest rates), a level most Americans can’t afford, said Cox Automotive. This more environmentally conscious generation may covet electric driver-less cars, but this is way out of their financial reach.

  • And of those Gen-Z’ers who do buy a car, many more in the older generations opt for used ones more and more.

 

Industry Cyclical Slowdown in Progress
For the first time in six years, first-quarter US car sales have fallen below 3 million units, according to a joint forecast by J.D. Power and LMC Automotive. At the same time data in the used vehicle market, according to a J.D. Power survey; saw wholesale prices of used vehicles up to 8-years in age fall by 1.5% in February relative to January. 
February’s performance was the month’s worst result in the past 20 years and only the second time there has been a material decline in prices during that time. 
“I got this old one; I want your new one!” The majority of new vehicle sales include trade-ins. So the more your vehicle is worth, the more buying power you have. It's part of the transaction. The new vehicle market is fuelled by replacement demand. ‘The more my old one is worth, the more new I can buy.’ If the price of your old car is declining you’re less likely to buy a new one. BMW finance and their second hand price guarantee understand this well. 

 

 

Surely China will make up for the Wests decline? 

Unfortunately no; as Chinese car sales are also in a cyclical decline.  

China is both the biggest manufacturer and the biggest market for cars globally. But after two decades of rapid expansion, sales fell in 2018 by 6% to 22.7 million units. There is no evidence to point towards a lasting reversal of this anytime soon.
 

 

 

BMW the Company - does it pass financial scrutiny? 
At a fundamental level BMW does not meet the 3 ‘must-haves’ we know to be present in great businesses of the future; 

  1. Benefitting from disruption (not threatened by it)

  2. Benefitting from a global Megatrends (tailwinds)

  3. Generating high ROIC. BMW’s ROIC of just 4.5% in 2018 compares to an average ROIC of over 40% across the companies in Insync’s portfolio. It must be said that car manufacturers don’t come close to our hurdle rate, and lets also leave Tesla to its ‘true-believers’.  

BMW is of course a great brand and optically it appears to be cheap, trading on 8x earnings. Quite often investors focus on P/E ratios. Thus, if it’s trading on a low PE ratio then investors automatically assume that it should be a buy, particularly when it is a well know global brand.
But the missing piece is the underlying quality of the business. What are the operating margins? How fast are they turning over their inventory? What about its profitability based on return on equity or invested capital?

         
Does it have a long runway of growth opportunities ahead beyond industry pipe dreams? Is the business at risk of disruption? How is the business actually generating sales and is this a sustainable way of growing its business? 

 

Our investigations and the answers we have compiled after thorough research have not filled us with the enthusiasm and confidence required to have it added to our portfolio. The numbers and the future prospects do not add up as a lucrative Future-Focused investment. 
We are happy to see a second-hand BMW added to the garage however.


Why does BMW trade on a low P/E ratio?

  • The automotive sector is notoriously cyclical where operating margins, using BMW as an example, range between 0.5% in 2009 and 10% today. It’s interesting to observe there has been no operating profit growth between 2014 and 2018 despite a big jump in sales increasing from €74.7Bn to  € 97.5Bn (+30%) over the same period.

  • BMW ROIC at 4.5% is very low (our portfolio average over 40%)

  • Risk of disruption: It’s not just the Gen-Z’ers we discussed earlier. Autonomous technology is set to change car ownership and usage. How well placed will BMW be in a highly competitive market? Will they be able to differentiate their vehicles in the same way as their traditional combustion engine cars?

  • Can BMW carve out as successful a share of the accelerating trend to electric vehicles as countries around the world implement policies for faster adoption? Norway already boasts over half of new car sales as being electric. China announced its New Energy Vehicle (NEV) mandate, part of its plan to sell 4.6 million electric vehicles by 2020 and ban cars with traditional internal combustion engines. 

  • Car finance is 44% of the total reported group profit at BMW from the automotive industrial business. What will happen to their profitability if ‘residual values’ of cars continue to decline? 

 

Conclusion 

Buying BMW with low profitability, at a time when we appear to be reaching a cyclical peak in the global automotive industry, and with the risk of major disruption ahead, seems like a highly risky proposition. They just can’t generate the ROIC, nor margins that will be required, even if they can stave off the structural decline in sales and the disruptive impacts of new technologies. Better global opportunities are more deserving of our investor’s capital.
A greater downside impact and probability of one, than there is upside in either is our assessment. 
BMW’s share price is depressed and for good reason. It may well bounce in the short term, but we are struggling to see how it will compound investor’s wealth beyond this. Certainly a low ROIC company, like BMW, with high risk of being on the wrong side of disruption does not fit into Insync’s universe of investable companies.

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