Sunday, October 7, 2018

The Swiss Fallacy

On September 20th, 2018, the Wall Street Journal [1] remarked how, despite strong economic growth, the Swiss central bank is refusing to raise interest rates. On the surface, it may appear as though the Swiss economy is booming. Up until the past few quarters, Switzerland’s housing market has been booming. The Swiss economy has less than 3% unemployment, 3.4% annual economic growth as of the 2nd quarter, and the Franc has risen sharply since 2011. Only within the past few years did the Swiss national bank decide to depreciate the currency. Then why does it make sense to keep rates low if the Swiss economy is as strong as the WSJ claims it is?

If it seems like a contradiction, check the premises. One of them must be wrong. While mainstream economists tout increases in “private consumption” as an indicator of economic growth, real economic growth is borne out of production. A depressed manufacturing sector [2], falling housing prices, and a stagnant construction sector belie the conclusion that the Swiss economy is in expansion. Manufacturing isn’t a small piece of the Swiss economic pie. It stands at 18% of Switzerland’s economy. A hit to manufacturing would be devastating. This may be the reason behind the Swiss central bankers’ reluctance to raise rates. Currently, the Swiss National Bank has stalled policy rates at -0.75%.

For readers that do not know, negative interest rates are a specified rate at which the Swiss National Bank calls for commercial banks to pay in order to park their excess reserves with the central bank. Essentially, the repo rate, or the rate at which the central bank lends to commercial banks, is negative. Commercial banks then pass on these costs to depositors’ savings.

Some banks have risen fees attached to private accounts or implemented fees for savings accounts rather than stop offering interest or charging negative interest as a subtler approach that allows banks to continue netting profits while not entirely losing their allure for investors. Lombard Odier charges negative interest of -0.75% to depositors who hold assets of more than 100,000 at the bank. Other private banks may soon follow.

Alternative Bank was first Swiss retail bank to implement negative interest rates. Currently, it charges -0.235% on up to 100,000 Swiss francs held in each private account, and -0.75% for amounts in excess of 100,000 francs. Negative rates aren’t applicable towards amounts up to 100,000 Swiss francs in savings accounts, but do apply excesses over 100,000 francs. Those funds are subject to -075% rates.

But what is the purpose of negative interest rates? It is in the interest of the Swiss national bank to coerce commercial banks to loan out the excess reserves. Excess reserves are those assets purchased through bond buying programs. Assets include monetized stocks and bonds, which the Swiss national bank has actively been loading up its balance sheet with. The Swiss national bank hopes that by loaning out those reserves [3], the consumption-fueled artificial boom will continue.

In reality, negative rates only make an economy weaker, and inevitably induce a boom-bust cycle.

Negative nominal rates distort the structure of production, by pushing bond prices up, and yields down into negative territory. These rates force the ratio between outstanding debt and GDP to shrink. By keeping the cost of borrowing artificially low, consumers respond by investing a dangerous aggregate in real estate, stocks, and other high yielding assets. What this means for the Swiss housing market is that mortgage rates are kept artificially low. This encourages unsustainable investments in long-term projects, like building homes or pouring money into large infrastructure projects with high costs of capital. Eventually, it leads to their oversupply [4] when rising raw materials costs cause rising selling prices to increase past the point at which consumers are willing to pay. When selling prices fall, they fall across all asset classes. Because consumers become dependent on real estate for income instead of savings, private consumption decreases as a recession hits.

On the financial system side, if central banks continue to lower interest rates to fight a recession, it could paradoxically result in rising market interest rates [5]. Because a bank’s income depends on spread between interest rate it charges to borrowers and the amount it pays to depositors, the more negative rates become, the more adverse depositors are to placing their money in the bank. If this leads to enough withdrawals, the bank may have to start calling in loans to satisfy depositors, and raise rates to entice them back.

It seems that the outlook isn’t as rosy as it is portrayed. With a potential downturn on the horizon, and eventual hits by rate hikes on both the production and consumption sides set Switzerland’s economy for anything but smooth sailing.

[1] Swiss Paradox: Booming Economy, Negative Interest,
[2] Swiss economic confidence held back by manufacturing,
[3] Where Negative Interest Rates Will Lead Us,
[4] Swiss house prices continue to fall,
[5] The Absurdity of Negative Interest Rates,

Friday, October 5, 2018

Continental AG

Stock Price: $150.55 / Market Cap: $30B / Enterprise Value: $35B
It’s déjà vu all over again. Many of the reasons that I found Daimler an attractive company also applied to Continental AG, with a few added bonuses.

1.     Continental’s Tire division has phenomenal margins, and a high return on operating assets. This can be attributed to three factors: a) Continental has the highest selling prices and the highest margins, which can only mean that they have significant pricing power, b) natural rubber prices have been depressed for year (excluding the temporary spike in late 2016/early 2017) due to an industry-wide oversupply of tires, and c) economies of scale matter the most in this business. Low production costs coupled with large volumes at high rates of regional growth have contributed to Continental Tires becoming the 4th largest tire brand in the world. In summary, Continental’s Tire division benefits from its supplier power, through high capacity and high volume, and pricing power.
2.     It’s hard, if not impossible, to reinvent the wheel. The tire industry, Continental included, is a durable industry. Despite the massive disruption towards electric vehicles and automation in the car industry, those cars will still need tires. Put another way, even if traditional diesel or petrol cars are at risk of going away, tires are here to stay.
3.     Continental is spinning off their Powertrain division. The Powertrain division is a commodity-margin, sometimes unprofitable business. Spinning the segment off would leave the rest of the company with higher margins overall. Management admits that It is at the risk of obsolescence as the market for electrified vehicles grows by a factor of 7-10 over the next decade, driving the traditional combustion engine segment more and more into the commodity corner. Government regulations require auto suppliers to build up new infrastructure, and there is more predictability in electric vehicles to adapt than the combustion engine. Power train requires highest level of flexibility making it hard to predict with the government regulated market environment.
4.     Tariff fears are overstated for Continental. Management themselves has admitted that the tariffs between US and China will hurt Chinese truck tire competitors more than the company itself. Continental can get around tariffs by manufacturing regionally, which it does already.
5.     Brexit fears, and the slowdown in China has also added downward pressure on Continental’s stock price. While Brexit fears are temporary, Continental also has minimal exposure to the UK market. As for the slowdown in China, despite this, Continental is seeing high returns on capital for its Tire division, as well as stable margins, so far unaffected by years of oversupply.
6. Continental is facing short-term production problems with the ramping up of production of complex 48 volt and hybrid vehicle systems. Operational costs and tax hits to the company amount to 350M and 100M, respectively.

Business Overview & Segment Information
Business Description
Continental AG is a leading global auto suppliers and tire manufacturer. The company is among the three leading suppliers in all relevant markets, and ranks second among the top 10 global OEM suppliers based on 2017 sales. Operations include chassis & safety, powertrain, interior, tires, and Contitech. Continental’s largest markets are Germany (20%), Europe (29% ex-Germany), North America (25%), and Asia (22%).
The passenger cars and commercial vehicles supply business accounts for 72% of total sales, while the global replacement tire business for passenger and commercial vehicles accounts for 28%. The five largest customers are Daimler, Fiat Chrysler, Ford, Renault-Nissan-Mitsubishi, and VW representing about 41% of Continental’s 2017 revenue.

Segment Information
Chassis & Safety (22% of total revenue)
This segment is responsible for the development, production, and marketing of intelligent systems to improve driving & safety and vehicle dynamics. Since the direction of the future is in mobility, chassis & safety is driven by electronic power. Overall, the segment grew 10.3% in 2017. Within the segment, divisions include advanced driver assistance systems (which experienced 40% volume growth in 2017 alone), hydraulic brake systems (including the electronic parking brake), passive safety & sensors, and vehicle dynamics.

Powertrain (17.5% of total revenue)
This segment designs the products that make driving more environmentally compatible and cost efficient. It is specifically related to manufacturing combustion engines, which have become under pressure by government regulation in recent years. Combustion engines face severe risks of obsolescence, and will be phased out by all auto manufacturers in the coming decade. Overall, the segment grew 7.3% in 2017. Within the segment, divisions include engine systems, fuel & exhaust management (which is also under pressure from emissions investigations), hybrid electric vehicles, sensors, and transmission. The sensors segment has continued record growth, and emissions legislation has resulted in rising sales of exhaust gas sensors.

Interior (21% of total revenue)
This segment is responsible for the communication and network solutions for passenger cars and commercial vehicles. Overall, the segment grew 10.1% in 2017. Within the segment, divisions include body & security, commercial vehicles & aftermarket, infotainment & connectivity, instrumentation & driver HMI, and intelligent transportation systems.

Tires (25.5% of total revenue)
This segment is responsible for reducing fuel consumption through creating tires that minimize rolling resistance. Overall, the segment grew 3% in sales volume in 2017. In 2015, high performance and winter tires accounted for 47% of total volumes sold at Continental. These types of tires are high volume, high margin, since customers have to pay higher prices for them.
Within the segment, divisions include passenger & light trucks, the replacement business (EMEA, Americas, APAC), commercial vehicle tires, and two-wheel tires. 29% of segment sales relate to business with vehicle manufacturers, and 71% relates to the replacement business. The largest passenger car tire replacement sales are represented by 29% in Europe, 24% in North America, and 38% in Asia (29% China). Medium & heavy weight commercial vehicle replacement tire sales are represented by 155% in Asia, 16% in Europe, 15% in North America, and 10% in South America. The global replacement tire market is expected to continue to grow by 3% CAGR from 2017-2022. China is expected to grow by 20% CAGR. By volume, Europe is the largest replacement tire market (CAGR expected to stay 2%). The tire division spends the most on R&D, which amounts to 11% of sales.

Contitech (14% of total revenue)
This segment is responsible for the development, manufacturing, and marketing of function parts, intelligent components & systems (made of rubber, plastic, metal, and fabric) for machine and plan engineering, mining, agriculture, and the automotive industry. Overally, the segment grew by 14% in 2017. 51% of segment sales relates to business with vehicle manufacturers, while 49% of sales relates to the replacement market. Continental’s tire segment has benefitted from a strong aftermarket business and favorable raw material costs.
Within the segment, divisions include air spring systems, the Benecke-Hornschuch surface group, the conveyor belt group, industrial fluid solutions, mobile fluid systems, the power transmission group, and vibration control. The segment recently acquired in Hornschuch Group, which is a leading manufacturer of the design of functional foam & compact foils, as well as artificial leather.

Raw Materials
40% of Continental’s purchasing volume goes towards raw materials. Steel, aluminum, copper, precious metals, and plastics are key raw materials. Carbon steel and stainless steel are inputs for mechanical components. Demand for carbon steel in Europe increased by 30% in 2017. Average stainless steel prices in Europe increased around 15% YOY. The price of copper increased 27% YOY, and the price of plastic granulates recovered, growing 30% YOY.
Meanwhile, prices for natural rubber have doubled since their 7-year low, increasing 20% YOY. This is due to a weather-related supply shortage.

Production Strategies
Continental’s product portfolio is diverse. It consists of high volume, low margin products, as well as low, volume high margin products.
Continental utilizes the “make to stock” strategy in which multiple production locations manufacture the same products. They utilize full truck load transportation, and custom made manufacturing tools, which are distributed in quantities related to the production capacities of the locations. Continental’s high degree of localization has contributed to its economies of scale.
However, some problems that Continental has faced in the past with this strategy include the lack of distributed planning, inconsistent data across businesses (which leads to forecasting issues), and different capacities across production locations.

Continental trades at a P/E of 10x, P/B of 1.85, TEV/sales of 0.81, P/FCF of 13x, P/OCF of 6x, EV/EBITDA 5, all well below its competitors.
Because each of it segments have varying levels of ROIC and growth, I decided to value it based on a segment-by-segment EBIT multiple analysis. I considered 4-6x mediocre, 7-9x average, and 10-12x superior.
First, I broke down ROIC by each segment in order to determine each division’s efficiency, or how well it of a return resulted from a base of given operating assets. As suspected, powertrain was the least efficient due to its high capital intensity and commodity margins, and Contitech was the most efficient due to its low capital intensity. Tires also demonstrated their efficiency, ranking second, from their economies of scale.

ROA by segment:
Chassis & Safety: 20%
Powertrain: 13%
Interior: 14%
Tires: 36%
Contitech: 70%

Then, I took a five-year average of revenue and EBIT in order to normalize margins. Using the assigned multiples, I came to an intrinsic value for each segment. The sum was Continental’s intrinsic value, which was approximately $200, giving the stock a 32% upside.

Chassis & Safety:
5-year EBIT margin: 8%
Multiple: 7x
Price per share: $25

5-year EBIT margin: 4%
Multiple: 6x
Price per share: $8

5-year EBIT margin: 8%
Multiple: 8x
Price per share: $25

5-year EBIT margin: 19%
Multiple: 12x
Price per share: $121.6

5-year EBIT margin: 7%
Multiple: 9x
Price per share: $19.5

Not only is Continental undervalued relative to itself, it is undervalued relative to peers on all measures listed below.

Operating leverage: 8%
Operating margin: 11.5%
Debt/equity: 0.18
Net debt/EBITDA: negative
P/FCF: 15x
P/E: 11x
ROIC: 14%

Operating leverage: 15%
Operating margin: 8%
Debt/equity: 1.2
Net debt/EBITDA: 2.35
P/FCF: 20x
P/E: 16x
ROIC: 3.8%

Operating leverage: 17%
Operating margin: 12.7%
Debt/equity: 0.22
Net debt/EBITDA: 0.16
P/FCF: 17.6x
P/E: 11x
ROIC: 14%

Operating leverage: 13%
Operating margin: 11%
Debt/equity: 0.53
Net debt/EBITDA: 1.26
P/FCF: 17.53x
P/E: 12.67x
ROIC: 11%

Operating leverage: 6%
Operating margin: 10%
Debt/equity: 0.34
Net debt/EBITDA: 0.5
P/FCF: 13x
P/E: 10x
ROIC: 21%

The above analyses do not capture the value of Continental’s R&D facilities and the capital invested into them. In April 2017, Continental opened up its first R&D facility in San Jose California. The research center is 6,000 square meters (65,000 square feet). While Continental management has not disclosed the dollar amount, it has said that in other Silicon Valley facilities, it has invested “tens of millions of dollars” each year since 2014. Looking at neighboring properties, I have calculated the land value at present prices to be around $2.6M dollars.

Continental has opened up its third R&D facility in Asia, opening one in Singapore in 2017. It has invested approximately $36M each year in similar facilities. The Singapore facility is 16,250 square meters.

Competitive Advantage
E-mobility will likely see rapid growth over the next decade. As a result, traditional automotive suppliers will face competition from new entrants. Any sudden changes in regulation could even lead to a disruptive e-mobility breakthrough as soon as a couple years.

To position itself on the “winning” side in the future, Continental AG is eliminating its “losing” segment. The traditional powertrain business is getting wound-down, and spun off. Tightened emission regulations will serve to further drive up complexity and the cost of the exhaust systems, especially for diesel. In the short-term there is revenue potential, but in the long run, there isn’t a future. Diesel is expected to continue its gradual decline in European market share over the coming years. The total per vehicle cost of powertrain will be driven higher by electrification and tighter emission requirements. Spinning off the segment will serve to make the average EBIT margin of the company higher, without powertrain’s commodity margin weighing it down. As it stands, powertrain is a no growth segment.

There are high barriers to entry through intellectual property in many innovation-driven segments. The overall competitive structure is becoming more consolidated in innovative driven segments, while there is still higher fragmentation in many process driven segments (such as powertrain), resulting in price competition.

Product innovators lead process specialists in terms of average profitability. The top process specialists, however, achieve average margins close to those of the top product innovators. The large difference in growth rates between top and low performing process specialists indicates the relevance of scale economies. Compared to large, global suppliers, small and midsize suppliers lag behind in terms of EBIT.

Continental already has the most digitized portfolio in the supplier sector. They have achieved that level of digitization not only because are one of the top innovators, but also because they have the advantage of economies of scale. Economies of scale drives the company’s higher than average industry margins in their innovation driven segments.

In Continental’s chassis & safety segment, margins have improved over time, as development is increasingly driven by advanced driver assistance and active safety. Management has forecasted that assisted & automated driving components could grow by as much as a factor of five until 2025.

While the industry overall has faced high commoditization pressure, Continental’s interior segment has reported higher than average margins. As with chassis & safety, the interior division benefits from economies of scale. The growing relevance of vehicle interiors will help support the segment’s above average EBIT.

As discussed in the “conclusion” section, Continental’s tire division should be largely immune from all the disruption in automotive industry. After all, electric and autonomous cars will still need tires. Fleets of autonomous taxis and shared vehicles will favor the established firms. Fleet managers tend to go for harder-wearing, safer tires. This will help maintain some moat for the Big Four tire companies against Chinese entrants.

As an aside, Continental tires are exclusive with Daimler, and as such, Continental does not have to compete with the other Big Three for Mercedes Benz brand vehicles.

As of 2017, revenue share of electrification, automated driving, and holistic connectivity is only less than 3%. It is expected to grow to 30% by 2025. Technologies that are expected to experience high growth (25-200%) are gasoline particulate filters, switchable coolant and oil pumps, and lane departure warnings. Medium growth technologies (15-24%) include turbochargers, start-top systems, and batter propulsion systems. Low growth technologies (5-14%) include electric power steering, touch screens, and adaptive cruise control.

Industry & Outlook
Within Continental, each market experienced varying rates of growth. Italy and Spain posted the highest growth rates (8%). Demand for passenger cars rose by 5% in France, 3% in Germany, and the UK saw a 6% decline. The US saw a decline of 2% in demand for passenger cars. The US demand for light commercial vehicles, especially pickup trucks, rose by 4% YOY. Russia, Germany, and Turkey posted the largest volume growth in the production of medium and heavy commercial vehicles. In South America, the recovery led to rising demand for trucks (20% YOY), specifically medium and heavy duty commercial vehicles.

Overall automotive growth for Continental was 9.2%. North American production of passenger cars and light commercial vehicles decreased by 4%, while global production of medium/heavy commercial vehicles by 12% YOY.

For Continental’s tire segment, there was an increase in demand for replacement tires for passenger cars & light commercial vehicles (11%). The expansion of global vehicle fleet is forecasted to grow 3.5% a year, and helps gradually to reduce firms’ dependence on the cyclical market for new cars.

The regions that saw high demand for replacements (those with growth rates over 10%) were Greece, the Netherlands, Sweden, Spain, and Eastern Europe. Demand in Russia & Brazil rose by 18% and 14%. The European replacement market saw a recovery from a sluggish first half year. The replacement market is still weak in China, with declining sales for passenger cars and rising inventories.

China’s tire industry has been suffering from huge overcapacity over the last decade. Since 2016, antidumping laws were bringing a huge influx of Chinese tires into Europe. Because Continental and the other Big Four are reporting profits despite this influx, it shows that they’re cost of production was falling.

The premium manufacturers of tires have cut costs and shifted production to cheaper places. Another helpful trend is rising raw material prices which combats oversupply of natural rubber and low oil prices. Large tire manufacturers like Continental also benefit from selling most of their wares directly to thousands of distributors. Their products also have an edge over Chinese tires. While Chinese tires are cheaper, they lack the performance and longevity of pricier brands.

Over recent years, raw material costs have been rising for Continental’s Rubber Group. The increase in fixed costs in the Tire division has resulted primarily from the considerable expansion of capacity. The division is starting up new plants in Mississippi and Thailand, and are expected to result in increases in depreciation & amortization, but also fixed costs before the plants generate revenue. The estimated cost to build the plants is around 120 million euros.

Financial Analysis
In the past five years, sales growth has averaged 7%, as has EBITDA growth. In 2017, sales were up 9%. The trend over a cycle seems that sales are up 9-14% one year, then drop to 3-4% the next. EBITDA growth also resembles this trend, up 10-17% one year, then 1% the next. In 2015, EBITDA grew by 10%. Operating margins have been very consistent for the past five years, steady at 10%. Net profit margins have also been consistent at 7% since 2013.

As for returns, ROIC has been consistently in the low 20s for the past five years. In 2017, it was 21%, and has dwarfed peers by a large margin, whose average is only 11%. ROE has also stayed consistent at 19%, and ROA 12%.

On the balance sheet, Continental’s current ratio was 1.1, and its quick ratio was 0.8. Inventory turnover was very high, at 7.9x a year, indicating high efficiency, especially for a manufacturer. There is no doubt that turnover is sustainable, as Continental has demonstrated its savviness in sustaining a high ROIC for most segments, keeping production costs low, and utilizing economies of scale to its advantage. Receivables and payables turnover has also been very consistent over the years. Receivables are turned 5.7x a year, and payables 4.8x. Continental’s cash collection cycle has also demonstrated stability.
According to management, Continental is intending to pile up cash on its balance sheet. The company’s LT debt/equity in 2017 was 0.13, decreasing every year by about 0.1 since 2013, when it had been 0.56. Other signs that Continental has been undertaking deleveraging are in its total debt/equity ratio, which decreased significantly from 0.9 in 2013 to 0.34 in 2017, and its net debt/EBITDA. In 2013, net debt was 1.2 turns of EBITDA, but in 2017 it was only 0.5.

Continental’s debt mix in 2017 consisted of 68% bonds, 18.8% bank loans and overdrafts, and 9.8% liabilities from sale-of-receivables programs. 67% of its bonds are fixed interest, and 33% is floating rate. Management financing strategy is to keep Continental’s gearing ratio below 20%, and ensure that it does not exceed 60%. In 2017, the gearing ratio was 12.6%. Continental’s equity ratio should also exceed 35%. In 2017, the equity ratio was 43.5%.

Free cash flow has been consistently positive for at least the past five years. FCF yields 7.7%, and roughly equals net income. Since the issuing of bonds is responsible for all of debt repayment, some of FCF goes towards dividends (25-30%), and a part of it goes towards acquisitions (6-9%). In the past, a larger portion went towards acquisitions (23-47%).

Interest coverage by EBIT grew significantly in the past five years, from 4x in 2013 to 16x. FCF coverage of interest went up by 8x, up from 2x in 2013. Cap ex as a percentage of sales (6%) has stayed consistent since 2013.

Continental is a business with high fixed costs. In the event of a downturn, when margins get compressed, usually liquidity becomes a problem. Luckily, Continental’s total liquidity is 5.9B, which is funded by both free cash flow and debt financing, is much larger than its total debt of 4B. Management has said that this should be sufficient if there is an economic downturn.

Anti-dumping measures in Europe and China have hurt truck tires capacity. Although this will have some effect Continental Tire’s division in China, it will hurt smaller Chinese competitors more. Continental’s Tires margins have shone resilience overall. In Europe, the EU has enacted anti-dumping laws, but the effects are still too early to tell.