Wednesday, 30 January 2008

Company Focus – Continental – Applying Traction Control

Perhaps the hardest commercial arena to operate within amongst the very diverse auto-parts sector has been Tyres & Rubber. This industry has few barriers to entry given its basic nature, and consequently there’s been a myriad of new, primarily Asian, operators seeking global ambitions over the last 20 years or so. The arrival of initially the Japanese, Korean, Taiwanese etc has slowly eaten-away at the once dominant market-shares of the likes of Europe’s Continental, Pirelli and America’s Goodyear etc.

During this period of increased competition the old-guard have sought to maintain margins by broadening product ranges and, critically re-positioning themselves as premium quality tyre producers for performance coupes/saloons and SUVs. Even so it was only a matter of time before fast-followers were encroaching and by 2005 Continental recognised it had to re-align its strategy by broadening its span of operations. Doing so by appreciating that the field of vehicles dynamics had radically altered over the last 10 years, the role of electronics playing a far greater role in vehicle safety and performance and so on-road behaviour – that was once the domain tyres relative to what were not so long ago antiquated suspension set-ups.

Of course the likes of anti-lock braking, collision warning, auto-brake, anti-roll control, hill-descent control, popularised four wheel drive and the return of four wheel steering (passive and proactive) have demonstrated that tyre-makers, as the previous gurus of vehicle control, have had to re-assess their position in the big scheme of things (ie encroaching basic tyre competitors and ever more prevalent involvement of vehicle electronics).

And needless to say, the rapid growth of BRIC nations (esp China) meant that local producers who have mastered what are basic tyre production technologies for western markets were ideally placed to satisfy local Asian demand for ‘commodity’ (ie cheap) products – leaving the sophisticated Europeans and Americans out in the cold.

To this end we have witnessed Continental seek new, critically important strategic directions, no doubt pushed for initially by its biggest share-holder, the new strategic formulae latterly appealing to recent others:

#1 Capital Group @ 5.10% (as of Oct 2003)
#2 Europacific Growth Fund @ 4.66% (as of Nov 2007)
#3 Barclays Bank @ 4.5% (as of July 2006)
#4 Marsico Capital Management @ 3.03% (as of Dec 2007)
#5 Axa Group @ 2.52% (as of March 2007)
#6 UBS AG @ 2.36% (as of Nov 2007)

One will immediately recognise that 3 of the 6 took their positions in Continental in late 2007, recognising the seismic change taking place and eager to buy at the then offered €101 per share – 14.6m shares offered – to provide €1.48bn capitalisation for continued M&A activities.

This was done on the back of reports that private equity had taken a substantial interest in Continental, but negotiations were mutually, unsuccessfully concluded. That PE catalyst proved to have problematic outcomes for the quick to jump institutional investors, as unfortunately, soon after company share-price dramatically faltered through Q407 on the back of US/European credit-crunch ripples affecting auto-demand and so component supplier order-books. Shares dropped from a €110 July high to a €73 low witnessed during the European auto-stock sell of last week. The recent new low – wiping over 25% off share-value, has come as a very unwelcome shock to the institutional investors – a low not seen since 18 months ago – so they will need confidence building by Continental to see a brighter longer term built upon a rapidly evolving Continental competence.

But for Continental, the end-October share-offer was timely indeed. Given its Q1-Q3 performance, or lack of relative to the DAX (-5.3%) and Dow Jones Euro-Stoxx Autos/Parts (-23.5%), the immediate market hype over the Siemens acquisition played out very well for the company!

It formed part of the financial foundations to action the Board’s (in our opinion late) realisation that it must broaden its philosophical sphere beyond tyres and traditional areas and onto being the Champion of Vehicle Dynamics, Route Positioning & In-Car Info-tainment.

To do so M&A has been the only real option, hence the additional share-offering - Continental purchasing Motorola’s Auto-Electronics Division ($1bn) and Siemens VDO (€11.4bn) – now both absorbed into the Automotive Systems Division; further bolstering a critical profit centre amongst the corporation’s 4 divisions:

1. Vehicle Systems Division (Elec & Hydraulic Brakes, Chassis & PT, Telematics, Elec-Drives, Body & Security, Aftermarket)
2. Passenger Car & Light Truck Tyres
3. Commercial Vehicle Tyres (Heavy Truck, Industrial & OTR Tyres)
4. ContiTech (Fluid, Air, NVH Control, Power Trans, Conveyer Belt, Elastomer Coatings)

[Additionally the Board sees that it must continue its conventional acquisition trail to essentially buy car and truck tyre market-share in Asia]

Of course historically Tyres has been the greatest Group contributor, but recent revenues in the Electronics arm now overtaking Tyres shows the importance of focusing on this sector and integrating Siemens to add down the road value (after post 2009 absorption) cannot be stressed enough. Reflecting that importance and impact, the Vehicle Systems Division will form the basis of 3 new divisions to aid efficiency:

A. Chassis & Safety
B. Powertrain
C. Interior

Although the star of the future, and newly crowned primary contributor, for the first three quarters of 2007 Automotive Systems was well out-performed in terms of earnings improvement by its less glamorous Car Tyre and ContiTech divisions, only losing out in growth stakes to a heavily set-back Truck Tyres. A seemingly lack-lustre growth performance was undoubtedly affected by the need to massively alter its operational shape to absorb Motorola and prepare for Siemens integration, as the fiscal information demonstrates:

Division / Revenue / YoY Improvement
Auto-Systems / €5,011.7m / 3.0%
Car Tyres / €3,646.6m / 62.1%
Truck Tyres / €1,069.9m / -3.9%
ContiTech / €2,810.7m / 12%

The effects of these figures demonstrated (in Q307 Results) a solid but frustratingly slow growth period in terms of sales (+€975.2m), improved earnings (+€165.8m) primarily gained through cost-efficiency initiatives; EPS up from €4.51 to €5.63

Of course although Continental like so many Auto-sector players has been “unfairly punished” by stock-market sentiment recently, the fundamentals of the business appear to be solid, and presently at the early days of what should be much improved revenue and earnings stream, specifically from the recent additions to the Auto-Systems division.

Western Tier1s and 2s have long recognised they must move further up the value-chain to avoid competing and ultimately losing to newer Asian peers in low-value manufacturing. Continental’s ambitions are now being realised and although there will be much re-organisational upheavel going forward, the business is already starting to look better and leaner. The newly obtained, far improved, geographical and technological reach able to provide considerable operational and fiscal improvement.

Once metals, rubbers and hydraulics ruled the auto-manufacture paradigm, but over the last decade, and with an exponential rise into the future, electronics are the new value-added 'fiscal core' of automobile module and parts supply. Continental is proving itself as a continued diversifier from old world rubber and hydraulics based realms to new-age electronic-centric platforms. The next step from there will be customer needs recognition (very much ruled by the parameters brand-attributes) and associative R&D expansion derived from marrying such 'similar-customer-enabling' to the ever demanded economies of scale.