Monday, 4 August 2008

Company Focus – BMW AG – Corporate Re-Engineering to Better Turn the Corner

The initials 'BMW' are renowned as representing the sine qua non of automotive achievement, in both respects as the creators of the archetype aspirant volume car and, as a consequence and more importantly for investors, the archetype ROCE & ROE value driven automotive company. From Wall Street's perspective it provided the returns that seem to mix the best of Porsche and Toyota.

It was a company whose very organisational DNA derived from the same ethos as that which engineered the cars – relatively lean and lightweight (in structure and reporting), a controlled centre of inertia (at board level), balanced masses (between R&D and productionisation), low unsprung weight (enabling quick action) and above all the ability to transmit, feel and read the external environment (reacting to its stimuli). In short a corporation, like its products, that was able to act beyond the sum of its parts. It was an environment developed by the likes of Piechestreider and Reitzle, a culture that merged old school Munich pragmatism with broadscope NYSE acumen to develop a focused product development capability set within a worldly, future-forward business strategy. This ideal was nurtured as the company grew on the back of the last 20 years worth of economic expansion in traditional markets, which boosted by ever expanding global liquidity and credit, allowed many an aspirant consumer to fulfill their BMW dreams.

But the halcyon days of BMW's auto-sector leadership have faded as the fall-out of the global credit-crunch takes effect and the middle-ground consumers, that could buy into the dream via credit and affordable product lines, seriously re-consider premium purchases. Of course, for a company like BMW it will be a test of how management rides the choppy waters of a possible global economic slow-down, even tho that slow-down still promises great Asian potential and the mid-long term prospect of a re-vitalised West post 2010...[note how commentators are pushing out the forecast for western 'bounce-back].

So whilst Piechestreider and Reitzle were able to enjoy their rapid expansionary and extremely profitable times at BMW, today's picture for Reithoffer looks very different. With slower revenue growth rates (expected given greatly increased volume) and far greater external macro headwinds. But the H108 results appears a bitter pill to swallow when global deliveries are up +4.7% at 764,874 units and group revenues are up +4.5% at 27.837bn Euros but group EBIT profitability is down -35.2% at 1.243bn Euros; of which only approximately two-thirds is automobile sales contribution.

The key indices chosen by BMW last year to demonstrate highline performance are EBIT-Margin [ie EBIT/Revenues] and ROS [ie Profit Before Tax / Revenues], measures seen as being analytically friendly and easily digestible for investor comparisons.

On these basis, the H108 vs H107 EBIT-Margin figures demonstrate a significant drop for the Group (at 4.5% vs 7.3%) due to a fall in the Autos division (at 3.9% vs 5.8%) and the Finance division (at 1.5% vs 5.6%). Whilst the Motorcycles division performance has stayed flat (at 12.5%). Similarly, the H108 vs H107 ROS figures tell a painful tale, Group down (at 4.5% vs 7.2%), Autos down (at 3.3% vs 5.5%), Finance down (at 1.9% vs 5.7%) and Motorcycles flat (at 11.8%).

The Finance division is perhaps the greatest concern given that BMW has historically been perhaps the greatest advocate of internal sales financing and thus benefactor; the credit crunch's effects are plain to see. Although the number of lease and finance contracts rose 12.9% vs H107, it must be recognised that the company has very probably been forced to tale-on lesser quality applicant credentials, given that other lenders have seriously retracted deals and that BMW will have had to partially fill the contract market's recent vacuum.

Unsurprisingly the company has adjusted its (we think) previously over-confident outlook, so as to portray a more realistic harsh consumer environment. [NB Many automakers were optimistic in forecasting an '09 upturn, now post-poned to 2010].

This re-assessed outlook will necessitate further internal re-alignment measures, that go beyond last years unpopular 4,000 post retrenchment, management stating that it seeks a staff cost overhead expense reduction of 107m Euros. This will partly assist the much needed provision (stated at a value of 695million Euros) required to offset the substantial devaluation of USA re-sale vehicle residuals. The US market has pounded BMW not only relative to the weak $ rate for imported vehicles, but also obviously hit hardest regards used car demand, premium used cars always suffer badly with economic declines. In reaction BMW is rightly decreasing volumes in a bid to maintain used and new car values.

All this makes for testing times indeed, as Reithoffer's press announcement stated “We will use the strong headwinds as an opportunity for change and continue the process of renovating and optimising our business in conjunction with strategy Number ONE. We must and we will intensify our efforts on both the cost and revenues side even further”.

Of course, in the face of such strong input cost and mature market stagnation headwinds organisational efficiency and improved productivity will be key, but the investment community will want to see detail behind the broad statements and obvious data such as data tables that highlight the sales success of !-series and Mini 2 in this cost-conscious environment. [A pertinent point to state that Mini ONE sales volumes need improving in its own right with targeted initiatives, done so intelligently without cannibalising the other higher margin variants]. Unsurprisingly the big car sales are down, with the exception of newly introduced X5. (Newish) 3-series is down 11% which given that it historically acts as the revenue standard bearer, but plainly the most demand elastic, is a substantial margin hurdle to overcome, even with the 'Efficient Dynamics' technology card played. Our real concern is new X6, and its abilities to meet mid-term western market volume targets, hear and now it appears more than just a little out of place, dare we say even folly-esque.

Small Cars will bear much of the responsibility and it is here that BMW really must demonstrate its commitment to the consumer and the capital markets. Whilst 1 series is improving in terms of market acceptance (esp Asia) and Mini has broadened its range with Clubman, greater exploration is needed to examine what other variants and spin-off models can be created. This will be the remit of the BMW-Alfa Romeo joint project team codenamed 'Butterfly' seeking conjoined engineering and production and possibly marketing synergies between the German and Italian corporations; saving approximately 250m Euros each. [investment-auto-motives believes the savings could be higher than the 150-200m Euro stated by analysts in Automotive News Europe 21.07.08]. But results, and critically income, will not be seen until 2012, so interim initiatives must be assessed to expand the role and contribution of BMW small cars, though possibly near-term constrained by UK and German capacity.

And beyond, as investment-auto-motives recommended over a year ago, BMW must examine the potential for its own equivalent of the 'Kei' category, yet smaller light-mass 'Quad' vehicles primarily dedicated to city use, spiritual successors to the 1960s Isetta in philosophy if not in style and function. BMW must merge its auto & motorcycle expertise to create a 'new order' for attractive light cars that follow in the footsteps of Daimler's >smart . We understand experiments / developments have since been underway (prompted by ourselves) but BMW R&D are being typically kept in the shadows. Once again BMW should seek another VM JV partner to develop the idea, ideally Daimler or Audi to promote prestige high-tech German origins and retain premium differentiation in the marketplace. Or indeed utilise the Mini brand to create a 2 tier, broader span, family.

Regards BMW's intrinsic sporting character, the new 2010 Z2 will do much to re-invigourate the compact sports segment, and theoretically should arrive when we see economic confidence return, so well timed for lower-cost, self-gratification personal motoring.

But in the meantime, on the input costs side of the commercial equation, BMW – like its VM peers – will need to negotiate hard with steel suppliers who are currently leveraging the incredible global demand by predominantly insisting on automakers paying 'spot-priced' steel – a result of their own inflationary input cost (iron ore and coking coal) experience. BMW needs to convince steelmakers that the recent economic explosion is set for slow-down with meaningful evidence, so as to negotiation sales back to longer-term contract-based agreements, providing improved revenue stability for the steelmakers, assisting them in their own CapEx planning.

As it stands here at mid Q308, BMW finds itself in a precarious position, with both heavier 'drags' than many of its peers (esp the European small car Vms) but also greater organisational and brand 'potentialities' that would assist a turnaround. The company must return to its philosophical roots and previous corporate 'go-getting' mentality. It must attune product and commercial acumen to plot its way forward – using the present headwinds to its own advantage. Joint Ventures will promote major cost savings but BMW cannot afford to dilute its unique and definitive offerings during what will be a very pressured period. But it is in such times that “who dares wins” and BMW is perhaps best placed, with its commercial momentum and R&D efforts such as GINA, to retain the crown as an originator.

And this is our concern. Reithoffer will be caught between the innate conservativeness of an understandably introverted, risk-averse financial management team and more extrovert product team. His and other Board member's remit is to balance the strategic friction, so as to keep the company on an upward glide path regards its cars and motorcycles, yet doing so with great great pragmatism.

The investment community demands greater transparency from Munich to see and understand how it will reach the rapid ascent from 2008's 4%, 2009's 6% & 2010's 8-10% EBIT-Margins. It will want to see more signs of BMW's confidence in itself and its future as the iconoclastic automaker.