BMW AG (XTER:BMW) – Globally speaking, auto manufacturers have had a challenging couple of years. Many are caught in the midst of a trade war and most are grappling with the rising popularity of electric vehicles, which brings new competitors and the need to spend considerable sums on new technology. Many auto makers have even had to face substantial legal issues, most notably related to diesel emissions and all of that has occurred in an environment in which auto sales growth has slowed in China and the U.S., which are, respectively, the world’s first and second largest auto markets. We are not dismissive and accept that those challenges are real but would also note that they have precipitated a multi-year valuation “de-rating” to extremely unusual levels.
However, the fact of the matter is that over the last twelve months, enduring all of the challenges noted above, BMW produced EUR 8.22 per share of earnings, which leaves the stock trading at 8x earnings on a trailing basis. Pessimism being acute as it is, the average analyst (and there are many) estimates that BMW will earn EUR 8.72 per share in 2019.2 We don’t dispute the consensus estimate per se but would note that if the estimates are correct, that would translate to a 13% earnings yield accruing to the shareholders, which is a return more than 50% higher than equity markets have provided over the long-term and less than half of the valuation at which the S&P 500 is trading. Furthermore, BMW pays out a substantial portion of its income to shareholders via dividends. During the quarter, BMW paid its annual dividend, which this year amounted to EUR 3.50 per share, translating to a 5.3% cash yield.
Looking through another lens, BMW has four primary sources of value: its auto making operations, its financing operations, which provide auto purchase and lease financing, its ownership interest in its Chinese joint venture and a large pile of net cash. At the current share price, if we subtract the net cash balance as well as the value of the joint venture and the finance business – valuing each at book value, which is an exceptionally conservative valuation - we are left with roughly EUR 9.6 billion of market value attributable to one of the world’s preeminent auto manufacturing businesses, which, mind you, produced pretax operating income of EUR 4.7 billion over the last twelve months. That equates to a valuation multiple of 2x pretax earnings for BMW’s auto manufacturing business.
Addressing several of the key debatable issues in as brief a fashion as possible (while inviting a more fulsome discussion from all interested):
- The Electric Vehicle (“EV”) Revolution – The concept of the EV revolution is often associated with the rule of thumb estimate that 30% of passenger vehicles sold globally will be electric by 2030. First, while EVs have garnered enormous attention, today they represent approximately 2% of global passenger vehicles sold.Given minimal progress to date on building out charging infrastructure for the masses in most geographies, we are doubtful that hoped for pace of adoption can be achieved. Second, an EV typically requires roughly 3.5 times the amount of copper that is used in a combustion engine car. By our math, the 30% adoption rate by 2030 scenario would translate to a 50% increase in the global growth rate of copper consumption, even without including the enormous amounts of copper required for charging stations and electric grid upgrades. Research firm Sanford Bernstein has estimated that, when including charging stations and electric grid enhancements, projected adoption of electric vehicles could raise global copper demand from a typical 2% growth per year to 3.5% per year, meaning a 75% increase in the consumption growth rate. Given that it typically takes ten years to permit and construct a new copper mine, we view the challenges to such a pace of adoption as very real and very likely to cause shortages and substantial cost inflation. Third, it is probable that electric vehicles will fit less neatly into ones ESG conscience as it becomes more widely understood that critical battery materials such as cobalt and lithium are produced in meaningful part through child labor and the leaching of environmentally sensitive areas, respectively. These facts will increasingly move into the foreground as EV volumes rise and the scope of the problems grow in step.
- New Competitors - Should the electric vehicle revolution surmount the challenges described above, we believe BMW will remain one of the world’s most successful auto makers. The most fundamental ingredients required of a highly profitable vehicle maker, electric or otherwise, will continue to be engineering prowess, manufacturing efficiency and lots and lots of money to fund research and development of new technologies, materials and manufacturing methods. BMW, already one of the largest EV producers in the world today, has access to the EUR 7 billion of annual pretax profit it generates, has a war chest of roughly EUR 16 billion of net cash on hand and has a global footprint of highly efficient assembly plants in the correct locations. BMW also has a robust global distribution and service network that is very difficult to replicate. Yet the most notable EV “disruptor”, Tesla, has produced losses of USD 969 million in the last twelve months, is indebted to the tune of USD 10.5 billion with its bonds rated and trading in junk territory, has struggled mightily to establish manufacturing efficiency and was recently forced to shrink its money-losing dealership footprint. We would also note that 2030 is 11 years away, which means that we are likely to see a couple of model refresh cycles between now and then, likely making existing models and technologies old and tired by then. The product offering Tesla has today may not carry it for very long with extraordinarily well-financed and capable competitors gaining rapidly. Again, a balance sheet, high levels of existing profit and engineering prowess are what enable success across model cycles and over time.
- Slowing Growth in China and the U.S. – It is indisputable that the auto industry has historically been cyclical. We are confident that will continue to be the case though we don’t know exactly where we are in that cycle. BMW is a luxury auto manufacturer and it seems not many people appreciate that the amplitudes of luxury auto cycles have historically been much smaller than for mass market autos. That dynamic can also be seen in recent U.S. and Chinese volume statistics, meaning the luxury market has been a good bit stronger than the aggregate numbers you read in the newspaper. Further, that U.S. and Chinese volumes have reached or surpassed previous peaks is not compelling evidence that we will face a near-term downturn. Auto volumes have grown substantially over long periods of time and that simple fact is likely to cause future peak volumes to be higher than past peak volumes. Most importantly, BMW has navigated many auto cycles, including several over the last three decades, during which shareholders have enjoyed a total return, in USD, averaging more than 10.8% per year for a total return of 1,984%, as compared to the MSCI World Index which returned 7.3% per year for a total return of 712%.
BMW’s outstanding compounding of shareholder returns has been accomplished by navigating many auto cycles, technological shifts and changes in consumer tastes while manufacturing efficiently and profitably to produce double-digit returns on book value over decades. Today we are able to acquire BMW shares at a 25% discount to that book value.
Furthermore, while BMW is today our largest Continental European holding, we see similarly attractive opportunities across our other Continental European holdings, which span a wide range of industries and fundamental business drivers. Virtually all points made above in regards to BMW pertain similarly to our position in Daimler AG as well.
From Third Avenue Value Fund (Trades, Portfolio)'s second-quarter 2019 portfolio manager commentary.
