Friday, 12 February 2010

Company Focus – BMW AG – Running Leaner Than Ideal Requires Ongoing Efficient Corporate Dynamics

BMW Stock Price (Frankfurt @ 12.02.2010, 16.25 GMT)
Preferred – Euro 21.61
Ordinary – Euro 28.85

BMW AG was undoubtedly hit hardest by the de-leveraging of western capital & consumer markets. Having enjoyed what could be viewed as the auto-industry's most impressive historic corporate rise through the 1980s, 1990s and much of the 2000s, the newer BMW management have had to alter its normative 'onward marching' modus operandi. Instead developing a combat campaign aimed at minimising consumer ground-loss and speeding structural reform, with what for BMW has been perhaps its most conservative, inward-facing, mentality in 40 years.

That about-face in management style was perhaps best witnessed in the tumble of BMW stock price during the crisis. The market's fear-factor, as ever, perhaps over-played the CapEx losses, but arguably just as equally valid is the over-play of optimism BMW stock has enjoyed during the 2009 equities rally, the company's Q309 report happy to demonstrate BMW's superior performance compared to 'Prime Auto' and the DAX30. From a 30th June 2009 re-base (of 100), by September end, BMW Common Stock enjoyed 133%, BMW Preferred Stock enjoyed 123% versus the DAX30 's 118% and 'Prime Autos' 104.5%. Thus as BMW management were still in the midst of still fighting to rationalise the corporation as a whole, the markets driven seemingly by over-charged sentiment foresaw a less dismal, indeed possibly far brighter, future for BMW AG.

[NB investment-auto-motives suspects that given Germany's need to lead the EU by example, lessen the national impact and in the run-up to its general election, there could feasibly have been leveraged an overt need to support an industrially optimistic self-fulfilling prophecy by the German institutionals, some of which themselves had been greatly assisted by Berlin's advocacy of targeted capital injections into systemically important players. Hence the possible 'belief-in' and support of German industry was a possible implicit expectation by the government, itself seeking re-election].

Prior to this latter-day period BMW management perhaps belated appreciated to forecast the crisis, but once comprehended endeavored to align operations to the very changed conditions seen over the last two and a half years. It recognised, as is the norm in contractionary times, that new BMW branded product identity had to both acquiesce to the less optimistic, anti-experimental western market mentality, aswell as creating a broader attraction within the more 'consumer-sporadic' EM regions. Thus the previous avante-garde brand aesthetic of 'flame-surface' was naturally superseded by less complex yet still deeply sculpted forms, with critically a far more 'Asiatic' influence upon lamp-cluster styling. Thus the central 3-series and 5-series models were reigned-in to once again become the front-runner, vanguard models in terms of core BMW identity and importantly to try and support profit margins. But under such conditions, gross margin, RoS, Net Margin and of course RoE were always destined to be the victims of circumstance.

As part of the build into a new era the BMW brand, ahead of Mercedes & Audi, has gained populist visibility with its ever-increasing Efficient Dynamics eco-initiative, which appears to on purely ecological basis set its cars considerably ahead of German rivals and nearly on-par with hybrid-powertrain Lexus models, using attuned conventional engineering and specific eco-tech solutions such as regenerative braking.

[NB as time progresses, we shall see theoretically all auto-manufacturers gain greater mpg & CO2 g/km figures. Product de-specification will enable reduced costs and accordant weight reduction. A probably low-fluctuation in oil price will enables greater use of larger and quality-improved lightweight plastics - as seen in the 1980s Citroen BX hood/bonnet. Bluff fronts-ends with wide gaping (airflow resistant) grills will be replaced by smoother-profiled noses and greater application of controlled under-body aero-dynamics improvements will respectfully assist Cd & CdA figures. And beyond other such conventional 'fixes' are specific eco-tech introductions ranging from start-stop to parallel and full hybrid technologies, and possibly the practical ideal of road-wheel or prop-shaft electrical generators, by far supplanting today's regenerative braking mechanisms.

However, in practical applicational terms BMW does indeed appear to be leading this transformational change today, just as Ford was in the early 1980s with Sierra, Taurus etc].

Thus BMW is increasingly well positioned as the present-day eco-premium carmaker, given Volvo & SAAB's periodic absence from what should ideologically be their 'eco-thrones'.

But in the meantime, the western demand for BMW branded products has taken a serious knock-back given that it more than other premium carmakers was able to, to a degree, financially engineer its success during the boom years via a mixture of marginal under-supply to maintain inelastic dealer-led pricing, dealer vehicle buy-backs to control used vehicle stock and residual prices and of course the innate power of BMW Financing. It was a self-perpetuating model which over the last 2 years has been partially fractured, and BMW is keen to rebuild.

Management is obviously keen to once again take control of the 3-way 'Productivity-Inventory-Demand' equation, and doing so will be the foundations to regaining industry-leading RoCE margins. Whether that profitability benchmark for a mass-manufacturer is once again achievable is open to question given the very different position BMW sits today, compared to its origins and growth story over the last 25 years. But investors less availed to the true dynamics of the sector will expect to see a return to the same levels of BMW's investor magic in due course – primarily driven by China volumes, if not directly enabled by the split appropriation of BMW-Brilliance profits.

A new 5-series will launch in 2010 so bolstering sales, and possible capture of E-class customers. However, unlike Daimler and E-class, BMW is having to be more tentative, so it follows largely in the 3-series format of styling conservativism. The off-set to that is 5-series Gran Turismo, but as to whether a 7-series derived, high-riding, hatch-back exec car is attractive to SMEs and private buyers is not yet apparent. The 'mixed-bag' various-cross-over formula in this segment has generated very mixed results ie poor R-class / good CLS / questionable X6. And so highlights the importance of getting the formula right for sales success, and not simply as a paper-based exercise driven by budget-hungry chief engineers keen to stretch platform capacities so as to reduce per unit costs which adds hypothetical weight to their board-room negotiating for corporate resources. Thus the X6 and 5-series GT could be said to be a test of BMW's management acumen as it battles to contain costs yet offer meaningful product.

But BMW's real concern is 1-series outside of its home market. It never became the Golf beater envisaged, especially so latterly, as consumers sought 'defensive' auto-purchases and VW grew the sub-brand equity of 'Golf' and its close-proximity variants. Previous mention that BMW seeks an alliance with another EU player (ie PSA or Daimler) must surely be re-visited as an investor-debate topic, the option being that it may develop a volume small car production business model with China Brilliance or indeed explores a JV with Japanese or Korean player (perhaps in tandem with PSA ie Mitsubishi or other). The problem is of course maintaining BMW product quality & driving dynamics standards – something a JV makes all the harder due to product compromise. Thus inevitably BMW will explore the technical option of inter-breeding 1-series and Mini, especially as VW Audi's A1 enters the fray, though given the very different packaging, engineering hardpoints etc, one or the other of BMW vehicles will demonstrably suffer from the compromise.

7-series has become for many an anathema, especially so in contrast to a very progressive S-class, which still essentially 'owns' China's large chauffeured-market and has made in-roads against 7-series elsewhere. Again, whilst holding its ground BMW must re-orientate the car so as to offer something very different yet credible whilst ideally maintaining RR Ghost and 5-series technical synergies.

In short, the BMW brand portfolio is indeed being renewed and the mix theoretically better, but the launch of 3 & 5-series (plus the X6 and 5GT creations) in the midst of the ongoing global economic drag will inevitably hit sales, and the previously devised project business models & IRRs, hard. The introduction of what should be a successful X1 (drawing from X3 and non-BMW) looks to buoy income, but realistically it will be a hard slog as BMW re-aligns to today's 'new norm' in the Triad.

The Mini division has unsurprisingly come under strain in the Triad region, even with the economic stimulus packages that have boosted the sales of smaller cars. As described in previous posts, Mini as a premium-positioned small car has passed its demand peak, the 2nd generation even though effectively all new Mini did not gain the renewed recognition given its visual proximity to the Mk 1 model, and so relied on new variants (eg Clubman & new Countryman). The fact that BMW had to balance a Mk 2 car in the Triad with an all new Mini entry in Asia always meant a law of diminishing returns in western markets. Reithoffer, Robertson and general management are seemingly pinning great hopes on the Countryman's urban-4x4 appeal to bolster the brand.

Industry observers have questioned the level of overlap between Clubman and Countryman,but investment-auto-motives' closer inspection leads us to believe BMW's strategy regards platform-utility maximisation, respective product positioning and divergent product attributes (ie Clubman's space versus Clubman's style) is valid. What is questionable however is volume expectation from these variants. Though not explicitly made public, investment-auto-motives believes that BMW management expectations may be higher than ultimately achieved.

With the intent of creating a modern classic the Mk2 car was visually little changed from its predecessor. The variant models obviously add alternative styles, but if not already tabled, the core 3 door hatchback must be given a long-life design plan which maintaining basic body shape and proportions, provides more impact regards nose and tail treatments. Likewise, a full exploration of 'Mini' (in the round) is once again due to better appreciate its place and future directional possibilities.

The Rolls-Royce division leads into 2010 with the Ghost model, smaller than Phantom, more sporting to combat Bentley, higher in forecast volume and contributing sizable margins borne from far greater BMW (7-series) systems sharing. As Bentley's Continental Flying Spur range ages, and the front-end look of new Mulsanne splits opinion (even if historically derived), the Baby Rolls looks to be the natural beneficiary, probable latter-day coupe and convertible variants selected in preference to Bentley GT and GTC.

Importantly, Ghost's pre-order book will have theoretically drawn-in valuable liquidity to possibly assist the RR division's ideal of self-financing – something we imagine is an implicit demand of BMW and a target of Tom Purves, RR CEO. [NB. As such, as a last resort for future funding, BMW would have a very attractive divestment opportunity, presumably retaining a large stake-hold].

However, negative RR concerns at present relate to defaulted/returned cars and the actual level of Ghost pre-orders – both issues combined possibly creating a heavy headwind. The possibility of higher than forecast payment defaults on 2008/9 sold Phantoms would have obviously decreased cashflow and increased the pre-owned inventory as cars were reconvened. This then puts pressure on independent RR dealers & BMW Finance to either drop residual values in search of sales, or set against short-term assets on the balance sheet at artificially high marked to market value. For those that also maintain classic Edwardian to 1950s RR stock that have enjoyed appreciating auction rates those used car values can be supported 'en mass' by classic counterparts, but for dealers without such classic stock, the value of recent 2007-9 pre-owned Phantoms cannot be 'assisted' within the general inventory dealer arrangement, thus create greater drag for BMW's RR Motors division on new Phantom pricing. The second concern is Ghost pre-orders. BMW's January YoY figures show a sales increase of 135%, which is we regard somewhat lacklustre given the revenue boost new Ghost was expected to provide, but we suspect Ghost has effectively become a for RR Motors revenue stream largely a Phantom substitute, increased sales balanced against reduced margins, Purves himself battling internally with Munich to maintain original contract-pricing for Ghost sub-structures and systems, whilst Reithoffer argues than RR should pay more to assist the BMW group as a whole. If RR is to remain the golden child, in terms of profit margins and the option to divest, Purves will probably stand his ground; but it is a topic more activist BMW investors should investigate more fully.

Ultimately for the BMW group, improving YoY sales data for January of +16% indicates that - unless a double-dip recession tales hold - the group-wide sales trough of 2008/9 has been passed. Yet given economic fragility in the West, and increasingly concerning in the East - if a China contraction effect takes hold – means that BMW still faces severe challenges.

But for the moment the W.Europe January increase of 1.5% (to 38,495 units), the CEE increase of 19% (to 2,237 units), Russia rising by 20% (1,129 units), N. America of 8.7% (16,608 units of which US accounts 15,410), Central America 10% (to 836 units), S. America 99% (1,057 units). In Asia as a whole sales rose by 74.6%, of which Chinese sales improved by 122% (11,919 units) [possibly due to the 'credit-effect' sales rush as highlighted in the previous Daimler posting].

The Motorcycle Division's unit sales increased by 2.2%, which reflects both the increased general demand for 2 wheeled transport in the Triad region, but negatively also BMW's missed opportunity to capture this surge, given its division's CoG in large tourer, sports-tourer, Enduro & super-sports segments. The largely failed commuter C1 project of the late 1990s saw BMW retrench to its core big-bike position, but it recognised the changing dynamics of global commuting (as did peers like Piaggio, Honda et al) hence its acquisition of Husqvana bikes & quadbikes in 2007. It still has not however, re-written the personal transport commuting rule-book, as undoubtedly intended. The MegaCity solo/duo leaning concept car born from BMW R&D's marriage of car and bike technologies looks more like an attention grabber to keep BMW looking advanced, rather than a pragmatic, revenue earning offering.

The Finance Division has obviously come under pressure in recent years, caught between the periodically shut, and still only partially open window for wholesale corporate funding. As a result BMW Finance was tasked in Q309 with seeking regionally-based 'official banking' and 'extended credit' licenses for Germany, France, Italy, US (banking licenses), and for India (extended credit license).As of yet no update has been given. It was also claimed that extra-ordinary EU funding would accessed once amenable, but recent sovereign credit concerns over Greece, Portugal, Spain etc indicates that liquidity will be directed at sustaining national balance sheets, so largely unavailable for wholesale, corporate & consumer access.

To conclude, BMW Group's prime aim has been to re-structure to the new norm. yet maintaining room for future re-growth, this achieved by the “balancing of retail vs residual vs volume”, generic levers for most car companies but historically far more sensitive for BMW. Critically BMW is having to manage its dealerbase, recognising that to hard a squeeze will pressurise their own working capital availability and so long-term survival prospects. BMW undoubtedly wants to see its dealerbase remain as is,string and healthy to help improve future sales volumes so as to break-even the capacity cost and move healthily into the black once more with buoyed FCF.

BMW missed its Q309 results expectations, and whilst better news arrives from across the globe in terms of sales, the battle to recovery is still harsh. FY09 results will be telling as to how well Reithoffer et al in Munich are controlling the situation....but for the moment it is still a case of rational investors holding their breath regards the corporate fundamentals...BMW is still in the fog, and little sign of either a powerfully combined product portfolio or financing flexibility provides a convincing case for immediate progress.

As such the juggling of balls between the Financial Services division and the Autos division looks set to continue, and whilst Q4's optimistic general economic outlook may well have translated into greater numbers of sold cars at the time, once again economic fundamentals and capital markets sentiment has soured somewhat whilst the Q4 purchasing trend by global SMEs that affects the premium-car sector may have been but momentary wind to BMW's sails.

By January end 2010 the outlook (as we predicted) is set to be tougher and BMW will need to - like Daimler - demonstrate its tactical and strategic planning...but unlike Daimler & VW its cash-cushion is far smaller, so far more dependent upon the criticality of recycled, squeezed and retained working capital management far more. That will frazzle supplier and dealer-network relationships, and will test the oft heard mention of the BMW family culture.