Saturday, September 29, 2018

Daimler AG (ETR:DAI)

Stocks Price: $54.87 / Market cap: $58,700M / EV: $173,612M

*$ implies euros, unless specified otherwise

Conclusion
Market overreactions make for great mispriced opportunities. Such is the case with Daimler, and the following five uncorrelated factors explain why Daimler is trading at recession multiples.

1. It’s not a problem of demand, it’s a problem of supply. Daimler’s challenges such as higher raw materials costs driven by inflation increases, negative effects of currency translation, and production constraints with US supplies due to a fire (caused supply chain constraints) are all temporary setbacks. In response to the problems listed above, management has been lessening their impact by cutting costs. As of this week, you can add the temporary suspension of operations at Daimler’s Mercedes Benz van factory in South Carolina ahead of Hurricane Florence. This is the factory contracted to produce 20,000 Sprinter vans for Amazon’s package delivery service (another growth opportunity).

2. Daimler faces the threat of tariffs on vehicles imported from Europe to the US, and also two-way tariffs between US and China. In response to these issues, management is redirecting auto shipments meant for China to neighboring regions to avoid the tariffs. While Daimler currently produces SUVs in the US and sells them into China (competitors Porsche and Maserati produce cars in Europe, ship them to China), the company is investigating new full-fledged production site in China. They already have a number of CKD production facilities in operation today in SE India (including India) which they are exploring as alternatives to get around tariffs.

3. Emissions scandals are plaguing European manufacturers and their reputation. Daimler, like Volkswagen is facing a lot of downward pressure on its share price. In June of 2018, it was discovered that up to 1 million Mercedes Benz engines contained an illegal “defeat device” in attempts to use software to cheat emissions tests on diesel vehicles. While Daimler has only recalled 238,000 vehicles (only those within Germany), it is expected to recall as many as 774,000. Global diesel sales, and especially those in Europe, are declining with diesel bans in Germany. Daimler’s global fleet exposure to diesel, while it is 38% of present (BMV 35%, VW 26%) will decline as the company shifts to electric with a strong focus on plug-in hybrid and electric vehicle models, and those natural gas driven. For its diesel vehicles, Daimler is updating software based engine management systems to restrain diesel use through diesel particulate filtrate system (DPF systems). In addition, it is manufacturing a family of low emission diesel vehicles. On the cycle side, while the diesel market faced oversupply in 2015, it is projected that there will be an upswing in demand in the coming months as oversupply has been created in the petrol market.

4. There is opportunity for margin growth in Daimler trucks if it is spun off. Daimler has been undergoing corporate restructuring which I see as a catalyst to unlock value should they separate the trucking division from the rest of the group. Daimler trucks, while currently the lowest margin segment, is positioned for growth after a tough 2016. In 2017, unit sales saw as much as 13% growth, and are expected to continue in 2018 and 2019.

5. Despite the adversities listed, Daimler has been seeing strong growth. Overall sales increased YOY by 7%, operating margins were steady at 9%, and unit sales were up 9%. The Group saw the greatest growth in South America with 7%, and the lowest in NAFTA and Europe, around 3-4%. Daimler’s trucking division saw a massive recovery in unit sales in Latin America, up 10% from its low in 2016. Mercedes Benz cars saw unit sales up 9%. Their reduction in sales was related to supply and not consumer demand from production delays due to WLTP certification (emissions).

Business Overview & Segment Information
Daimler is one of the leading global vehicle manufacturers. The company is engaged in the research and development, production, and distribution of cars, trucks, vans, and buses in Germany. The Mercedes Benz Cars segment operates under the premium brands Mercedes Benz and Smart cars. The Daimler Trucks segment develops and produces vehicles under Mercedes Benz, Freightliner, Western Star, FUSO, and Bharat Benz. The Mercedes Benz Vans segment is a supplier of a range of vans and associated services. The Daimler Buses segment sells completely built-up buses under brand names, including Mercedes Benz and Setra. The company also has a financial services segment called Daimler Financial Services.

Mercedes Benz Cars: 55% of Group revenue
The Mercedes Benz brand is the number one manufacturer in the premium segment in Germany, core European markets, the US, in Canada, S. Korea, and Japan. As of 2017, China accounted for 26% of unit sales, the US 14%, Germany 13%, and all other European markets 29%. The automobiles range from compact models to highly varied program of off-road vehicles, roadsters, coupes and convertibles, as well as S-class luxury sedans. The portfolio also includes high-quality small cars of the Smart brand. In 2016, the segment introduced the new EQ brand, which consolidates all of the company’s activities related to electric mobility. The segment’s market share is 6.3% in the EU, 10.5% in Germany, 2% of the US, 2.6% of China, and 1.7% share in Japan. Mercedes Benz cars are manufactured in Germany, South Africa, France, Brazil, Hungary, and the US. They are assembled in Thailand, Vietnam, Indonesia, Malaysia, and India.

Daimler Trucks: 21% of Group revenue
The segment is the world’s largest manufacturer of trucks above 6 metric tons. It operates under various brands: Mercedes Benz, Freightliner, Western Star, FUSO, and BharatBenz. As of 2017, the NAFTA region accounted for 35% of unit sales, Asia 32%, EU30 region (EU, Switzerland, Norway) 17%, and Latin America 16%. Daimler Trucks is the market leader in the EU30 region with 27.6% in medium and heavy duty trucks. It has 40% share in the NAFTA region, and the FUSO brand has 19.6% of Japan’s market share. In India, the Bharat Benz brand has 9.1% share. The segment has manufacturing facilities in various locations in the US and in Mexico.

Mercedes Benz Vans: 8% of Group revenue
The segment is a global supplier of vans and associated services. Mercedes Benz Vans was the first premium manufacturer to introduce a series in mid-size pickups. The segment has manufacturing facilities in Germany, Spain, the US, Argentina, China and Russia. The EU30 region accounts for 68% of unit sales, and the NAFTA region 11%. The segment has market share of 16% in the EU30 region, 27.3% in Germany it was 3.1%, and 7.5% in the US.

Daimler Buses: 3% of Group revenue
The segment has a European production network with manufacturing locations in Germany, France, Spain, and the Czech Republic, as well as plants in emerging market countries such as Turkey, Argentina, Brazil, Mexico, and India. 67% of its revenue comes from the EU30 region, and 17% from Latin America (ex-Mexico). In the EU30 region, Daimler Buses has a market share of 28.4%, and in Brazil it has a market share of 52.5%.

Daimler Financial Services: 13% of Group revenue
The segment leases and finances 50% of vehicles sold by Daimler. It has a 45% interest in Toll Collect, which operates electronic road charging systems for trucks on highways in Germany. 

Valuation
Daimler trades at very low multiples: PE of 5.58x, P/B of 1.14x, P/FCF (industrial) of 11x, and EV/EBITDA of 8.5x. The stock is down 26.8% YTD, and down 51% since 2015.

Daimler Group has a lot of moving parts. As such, I believe the most accurate way to value the company is to place multiples on each segment individually.

In order to normalize operating income for each segment, I took the three-year average, and applied them to each segment’s revenue. The valuation below indicates a 62% upside.

(Revenue in millions of euros)
Mercedes Benz Cars: Revenue (3-year average): $89,263
EBIT margin (3-year average): 9%
EBIT/share: $7.87
Multiple: 8x
Intrinsic Value per share: $62.96

Daimler Trucks Revenue (3-year average): $35,491
EBIT margin (3-year average): 6%
EBIT/share: $2.15
Multiple: 9x
Intrinsic Value per share: $19.35

Mercedes Benz Vans Revenue (3-year average): $12,491
EBIT margin (3-year average): 9%
EBIT/share: $1.01
Multiple: 6x
Intrinsic Value per share: $6.06

Daimler Buses Revenue (3-year average): $4,123
EBIT margin (3-year average): 6%
EBIT/share: $0.22
Multiple: 3x
Intrinsic Value per share: $0.66

Sum of segments intrinsic value per share: $89.03

I excluded the financial services segment and instead focused on the industrial business. Leaving out financial services will leave the company with a more attractive valuation, and profitable position if looked at from a FCF standpoint instead. For the multiples, I considered 2-3x mediocre, 4-6x average, and 7-9x superior. Each segment was valued on the multiple depending on growth opportunities and outlook. Some segments such as Daimler Trucks and Mercedes Benz Cars, will have higher multiples. Mercedes Benz cars in positioned for greater shift in the fast growing electric vehicle industry, and the truck segment will be more valuable if spun off.

Daimler also owns a 3.1% stake in Renault & Nissan, a 49% stake in BBAC ($1,134M), a 10% stake in BAIC Motor ($112M), and a 33.33% stake in THBV (not public). As of this week, Daimler also bought a 20% stake in Volkswagen’s HeyCar (dollar amount not disclosed), a used car platform. The stakes in BBAC and BAIC add $5.11, and the stake in Renault adds $2.16 to the share price. For the sake of this valuation, I will not add them to intrinsic value, because of the focus on the core operating business. Nevertheless, its equity stakes have significant value.

Competitive Advantage
While the auto industry is facing major disruption from the shift away from petrol and diesel vehicles to electric and autonomous vehicles, Daimler is taking action to put the odds in their favor. Though the future is uncertain, and it can’t be guaranteed that they will win, the IONITY joint venture with BMW, Ford, Volkswagen, Audi, Porsche provides some shield or moat against standalone tech competitors. This strategic alliance is concerned with e-mobility and developing a European charging network for electric cars.

In continuing with strategic partnerships, Amazon ordered 20,000 Mercedes Benz vans (delivery by end of 2019) to build out its delivery fleet and have small businesses carry an excess supply of packages. Growth in B2B business packages which requires Amazon to expand its fleet has indirectly helped Daimler. Amazon won’t own the vans and will instead lease them out to small delivery service providers.

In addition, Daimler is pouring R&D into their fast-growing mobility activities. Daimler has the 2nd highest R&D budget among its peer group. As a recent article stated, Daimler is sacrificing short-term profits to increase R&D expenditure. I see this as a positive sign, indicating that Daimler is a sort of quasi-Fisher company positioned for growth, but at the same time is constrained by cyclical commodity elements being an automotive manufacturer.

Daimler Group was the first international manufacturer to receive a test license for fully automated vehicles in Beijing. In addition, Daimler is investing in private car-sharing services and other mobility systems as alternatives to traditional passenger transportation. Daimler is the world’s leading company for flexible car sharing with car2go, and owns Europe’s leading taxi app, myTaxi. Daimler Buses is investing in plans to produce the first fully electric city bus line (Mercedes Benz Citaro, currently hybrid) for metros in Latin America and Europe. By 2025, the company projects that 15-25% of new Mercedes Benz cars will be electric models.

World Outlook & Industry Demand
The company expects world demand to grow by 2% in the next year. In 2017, the auto industry saw a peak with oversupply from higher volume. This led to slower sales growth, and lower prices.

For Daimler, the European market continues to be very important, as the biggest sales market for Mercedes Benz cars and vans. Car demand in Europe was higher following the recovery. The market volume in Western Europe was above average, and there was a significant increase in sales volume in Eastern Europe due to the ongoing recovery in Russia (up 12%). The Chinese market continues at high volumes.

The UK market suffered a decrease of 6% after record volumes in 2016 due to instability from Brexit wrecking havoc on the European auto industry. In the US, volume for cars and trucks was down 2%. In the coming year, Daimler expects a significant increase in NAFTA with the cyclical recovery of the truck market. The demand for medium and heavy duty trucks is recovering from the weak phase, and saw an upswing in 2017 by 13%.

Demand for large vans in general is up 9%. The company expects bus volumes to be influenced by economic upturn in Argentina and Brazil. Buses saw significant decline in 2016 and a turnaround in 2017. The recovery is expected to continue into 2018.

In Europe, there are temporary restrictions on availability of vehicles, causing customers have to switch to vehicles with lower margins. This is due to the emissions certification causing production delays in some products, and overcapacity in others. Overall, there is unchanged high demand for Daimler’s products. Management expects the situation in Europe to normalize in the fourth quarter, and for inventories to be reduced again by the end of the year.

Financial Analysis
For the past five years, Daimler has averaged 8% revenue growth, with growth as high as 10-15% in 2014 and 2015. From 2016-2017, sales grew 7%. Since 2015, R&D growth has been ramped up to 15%, and R&D sales have stayed consistently between 6-7% of sales over the past 10 years.

True to a cyclical, EBITDA growth has been consistently erratic since 2011. Without fail, it goes up in the high teens one year, then drops to low single digits the next. In 2017, it was in the low double digits, which may mean low single digit growth is expected in 2018. And just in time, the stock is trading at a discount. If you look at EBIT growth, you see the same exact trend. Up low 20% one year, down to -1 to -2% the next. In 2017, Daimler saw 14% growth. See a pattern?

Earlier this year, management issued a profit warning. Net profit has followed the same general growth trend as EBITDA and EBIT. In 2017, it saw the largest growth (24%) since 2013.

As for returns, ROIC has been consistently dismal at 4% since 2010. ROA has been slightly better, but still low at 6% since 2011. Lastly, ROE is significantly greater, ranging from 15-17% since 2011. As of 2017, ROE was 16%.

On the balance sheet, Daimler’s current ratio has increased from 1.19 in 2013 to 1.23 in 2017. Its quick ratio has increased slightly from 0.9 to 0.93 during the five-year period. Working capital turnover has decreased over the past five years from 10.4x/year to 8.4x/year. Written another way, 11.9% of working capital is financed per dollar of sales. Daimler turns inventory 5x/year, payables 10x/year, and receivables 14x/year. Trade payables slightly outpace receivables on the balance sheet, but turn slower than receivables meaning that Daimler receives cash from customers before it pays suppliers. Its cash collection cycle has been stable over the past five years.

Backing out its financial subdivision, Daimler’s 2017 net debt is 3.9x turns of EBITDA, and the company has a debt/equity ratio of 1.58. Daimler is roughly in line in terms of leverage compared to its peers, but slightly higher. VW has a net debt/EBITDA of 3.98x, and debt/equity of 1.19, while BMW has 3.68x, and 1.14. The composition of its financial liabilities (excluding those concerned with the financial subdivision) are bonds (funded debt) and loans owed to banks and commercial paper (bank debt). 53% of its financial liabilities are bonds & notes, and 27% are loans owed to financial institutions. Whenever Daimler needs refinancing, it issues bonds. A large proportion of the company’s corporate bonds are sold in the euro and dollar markets, and in China (denominated in renminbi). Last but not least, for interest, EBIT covers interest expense by roughly 25x, which has been growing consistently compared to coverage in the past.

Operating cash flows have been consistently positive. In 2017, they became negative primarily due to an increase in receivables in the financial subdivision. While the Group’s FCF has been consistently negative, it is also due to an unprofitable Daimler Financial Services. The FCF of the industrial business has been positive. As of 2017, industrial FCF yields 9%. FCF growth for the industrial business peaked in 2015, and has been declining since with heavier capital expenditures. Looking at the past 10 years, it appears that FCF has peaked twice: once in 2010 and the other in 2015, indicating a FCF cycle of 5 years. Financing cash flows have been consistently positive since 2011, and have been consistently greater (roughly 2-3x) than operating cash flows.

Since the issuing of bonds is responsible for debt repayment, all of the industrial business FCF goes towards paying dividends for shareholders. Daimler’s dividend yield is approximately 7%, and is sustainable in relation to FCF yield (9%) and earnings yield (17%).

Risks
In my opinion, Daimler’s risks are related to debt. As discussed in the annual reports, there have been an excess increase in credit defaults in China. For the Mercedes Benz Cars division, China is now the biggest individual sales market by a large margin. Credit defaults will have an adverse effect, especially on leasing, which will also affect Daimler Financial Services, which carries out roughly 50% of all vehicle lease contracts. Secondly, while the current cost of financing debt is very low, if interest rates rise, Daimler (and its competitors) could have trouble financing its debt.

A Personal Statement on Rational Investing

In Security Analysis, authors Graham and Dodd defined intrinsic value as the “value which is justified by the facts...the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.”

Similarly, while Mises did say that “human action is necessarily always rational,” he also acknowledged that in an artificially low interest rate environment, when the natural rate of interest has been manipulated by central banks, consumers and entrepreneurs are more likely to coordinate their actions with others.

This translates over to the stock market directly. As we’ve seen with the FANG stocks, some trades get much more crowded than others, creating market inefficiency. It is up to the value investor to think very differently than the general investing populace, and look for opportunities where securities whose intrinsic value has not changed, but their prices have become depressed.

Being a value investor requires some patience, some diligence, and some unconventional thought. I find that limiting myself to one industry, one market cap, and even one market is counterproductive to finding opportunities where value may lurk. Widening the horizons should not solely be confined to time.

One of the most rational statements I've heard is that "there's always a bear market somewhere." The job of the value investor is to find where.