Stock Price: $150.55
/ Market Cap: $30B / Enterprise Value: $35B
Conclusion
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.
Valuation
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
Powertrain:
5-year EBIT margin: 4%
Multiple: 6x
Price per share: $8
Interior:
5-year EBIT margin: 8%
Multiple: 8x
Price per share: $25
Tires:
5-year EBIT margin: 19%
Multiple: 12x
Price per share: $121.6
Contitech:
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.
Bridgestone:
Operating leverage: 8%
Operating margin: 11.5%
Debt/equity: 0.18
Net debt/EBITDA: negative
EV/EBITDA: 4.6x
P/FCF: 15x
P/E: 11x
ROIC: 14%
Goodyear:
Operating leverage: 15%
Operating margin: 8%
Debt/equity: 1.2
Net debt/EBITDA: 2.35
EV/EBITDA: 5x
P/FCF: 20x
P/E: 16x
ROIC: 3.8%
Michelin:
Operating leverage: 17%
Operating margin: 12.7%
Debt/equity: 0.22
Net debt/EBITDA: 0.16
EV/EBITDA: 4.8x
P/FCF: 17.6x
P/E: 11x
ROIC: 14%
Average:
Operating leverage: 13%
Operating margin: 11%
Debt/equity: 0.53
Net debt/EBITDA: 1.26
EV/EBITDA: 4.8x
P/FCF: 17.53x
P/E: 12.67x
ROIC: 11%
Continental:
Operating leverage: 6%
Operating margin: 10%
Debt/equity: 0.34
Net debt/EBITDA: 0.5
EV/EBITDA: 5x
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.
Risks
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.
