I like the title’s assertation. It has given rise to a lot of mispricings – many of which have been kind to me.
Auto sales have been “peak” for the three years running and the imminent subprime auto bubble is always going to burst tomorrow. The media, financial, and business world have beat this drum pretty consistently. Because of the drumbeat, there has been a constant pessimism in the prices of auto-related businesses. Though that pessimism looks to have recently begun to unwind – if not just slightly. GM is finally getting some love, FCAU has seen the love, CACC keeps on doing what they do best (keeping their head down and performing) and they’ve received love. Even MNRO has seen a tiny bit of love.
Perhaps auto names are simply one of the last sectors to join this bull-market fiesta, or perhaps the drumbeat has been plain wrong…or maybe just early.
Nobody goes to that restaurant anymore; it’s too crowded.
The curious thing is that when everyone knows something is risky, that’s when it’s the least risky. And when everyone knows something is safe, that’s when it’s the riskiest. Risk is the stuff we’re not watching, can’t see, and can’t predict. Everyone knows auto-related names are risky. Everyone knows it’s peak auto. Everyone knows trends in the subprime auto realm will end badly.
Then again, maybe everyone’s actually right.
Bavarian Motor Works
BMW is an interesting (family) business. And a simple business. For 100 years, the Quandt family has owned and mostly controlled the business which consists of an auto manufacturer and a bank. The manufacturer makes cars (BMW, Mini, Rolls Royce) and motorcycles. The bank makes short-term loans to its customers and dealers to buy and finance those cars.
BMW, as opposed to most auto manufacturers, has an impressive history with a decent record in capital allocation. The business has been run conservatively and even eeked out a profit through the great recession – a huge feat when compared to the likes of American automakers (Ford lost over $14B and GM lost $31B then went broke). On headline numbers today, the business is trading at 8x earnings. Considering we’re late in the cycle, those are probably peak(ish) earnings – so perhaps that’s a fair multiple. But it’s worth looking deeper.
The bank is the lending arm of BMW. It finances about half of the automobiles sold by BMW, and last year BMW sold about 2.4 million vehicles. The bank has a solid operating history and even through the depths of 2009 it had less than 1 out of 100 loans go sour – an impressive feat considering the backdrop (the actual figure was 0.84%), which led to a pre-tax loss of €290M within the banking division. Considering their borrowers are BMW drivers, the somewhat circular logic leads to a lower than average credit risk customer pool.
The bank is underrated and mispriced. It currently earns mouth-watering returns on equity (for a bank). Over the last 5 years, ROE has been over 20%. By comparison, companies in the US banking industry averaged 9.75% ROE over the first half of 2017 and trade at an average of 1.34x book. Over longer time periods BMW’s normalized ROE is about 18%. WFC and USB are the two banks most revered for their ROE achievements. Their respective ROE’s over the past 10 years have averaged below 15% and their businesses have traded at ranges between 1.5x to 2.1x book value. Not necessarily apples to apples, but a reasonable look-through.
With BMW bank achieving ROE’s of 18% it ought to be worth at least 1.6x book value. Meaning, if someone bought the bank for that price, they’re buying an 11.25% yield (18%/1.6). For comparison sake, If I’m incredibly generous to indexers, I might say they are paying 20x earnings for buying the S&P 500 today. Those 20x earnings mean they’re buying a 5% yield (1/20). Although in today’s market I think BMW bank is worth closer to 2x book, we’ll leave it at 1.6x. Hence, we value the bank at €18B.
The Auto Business
The auto business has net cash of €22B. Managment has lead us to the conclusion that at least €12B of this is excess cash not needed to run the business. That’s difficult to verify independently as I can’t sort out how much cash is truly “excess”, so we’ll take management’s word.
If we pause here, we’re at €12B in excess cash + €18B of value for the bank = €30B of value (or €45.66/share). The market cap of BMW today is €57.2B – BUT we can buy the economically equivalent preferred shares at a market cap of €49.3B or €74/share. Effectively, we spend €19.3B (€49.3 -€30) for the earning power of the auto business…which produced about €5.75B in free cash flow in 2016. Meaning, we can buy the auto business for 3.4x earnings.
That may be confusing, so here it is again. We are buying the BMW bank conservatively valued at 1.6x book value for €18B. We’re getting €12B in excess cash in the auto segment, and we pay 3.4x TTM (trailing twelve months) earnings for the automotive business.
I can hear you already, practically yelling “BUT IT’S PEAK AUTO! … the multiples you are quoting are based on peak earnings today. The multiple you are paying on normalized mid-cycle earnings are much higher than 3.4x“. To that, I’ll simply say you are mostly correct. So here’s another way to look at it over a cycle if you are actually the rare bird who holds a business for years vs. quarters:
Company-wide ROE has averaged 13.3% over the past 10 years including the great recession. ROE only dropped below 14% during the great recession to about 1% in 2008 and 2009. Today, because we can buy the business right at book value of €75/share, that 13.3% ROE is or should be very similar to ROI. Not horrible.
You want real peak auto? Okay. Book value per share at BMW has grown at over 10% for the past 10 years including the great recession. Let’s assume that drops to an average of 6% growth for the next 5 years. That’d put book value per share ending 2022 at €108. But let’s also assume that average ROE’s drop to new-lows and comes in at 11%/year. That means in 2022 BMW has €11.90 in earnings per share. Is the business worth book value at that point? With presumably no “peak auto” overhang? If so, it would be trading for 9x earnings. At a 30% payout ratio, you would have collected €15.90 in dividends in the meantime. Over the next five years, we’d own it at €108/share price plus €15.90 in collected dividends. That comes to a 10.5% CAGR on pretty conservative/pessimistic scenarios.
BMW is interesting for more than it’s apparent cheapness. Moat-like returns on equity and invested capital appear when one studies the business vs. its industry over longer periods of time. It’s proven an aspirational brand for most of the world and hasn’t lost its luster. 30 years ago, BMW was an aspirational brand, and it remains so today – and I presume it will continue to be that way decades into the future. Forbes has BMW as the 21st most valuable brand in the world with the “brand” worth $28.7B. BMW’s balance sheet only shows intangibles of about €8B. I don’t know exactly where Forbes comes up with the numbers they do, though I do know this: BMW buys various commodities, repackages them and sells a brand. They have some pricing power in the process. There are not a lot of businesses like that.
BMW also fits into my view of our economic future. There were maybe two BMW’s in my decent-sized town growing up, and now there’s probably 10,000. The story is the same all over the world. The world is getting richer. Over extended periods of time, I don’t think that will slow down even with a monetary apocalypse. Buffet has spoken a lot about the improvements in wealth and quality of life over the past 50 years and I think we’re only in the beginning. Sure, a lot of this is due to the extension of credit and comfort with debt, but again, I also don’t think that comfort changes with the exception of temporary credit freezes in rough times. There is simply too much money to be made by lenders (in good times) that future bad times will again prove be temporary – even if we are lending in bitcoin. With all the wealth being created and standard of living improvements riding alongside, the human entitlement gene will probably also make us more willing to live outside of our means than we are today. The extension of credit is too seductive and the entitlement and envy genes too strong.
BMW has also proven difficult to kill over its 100 year life. It has a long successful history and has adapted well to varying climates. The management team is not overpaid and shareholders not abused.
The obvious questions and risks are in things like:
- What will electrification do to the auto industry? BMW has the i3 and i8 though neither has proven a success. They are loss leaders – similar to Tesla’s entire fleet 🙂 It’s really difficult for me to predict where electrification will go from today’s 1%. One basically has to believe in the disruptability of BMW’s managers and technology. Up to this point, both the management and use of technology has been leading the industry.
- Will self-driving cars come to fruition, reach critical mass, and will individual will car ownership plummet?
- Who will be left behind in the self-driving/auto technology race? BMW has some good partners in Intel, Mobileye, and Delphi, but I’m not sure which manufacturer is actually in the lead and whether that lead is a good thing or not.
- BMW has been lying about their emissions and we see dieselgate part II.
- What about Clayton Christensen’s theory of disruption? Why can’t an Elio or someone better and smarter come in at the bottom of the market and steal an incredible amount of wallet? BMW may be more insulated in this regard than is Toyota, Honda, Hyundai, etc., but it’s still a big risk.
- China is a huge market for automakers now and in the future. India will be. Can BMW effectively compete against local manufacturers who have the government on their side?
- Tesla takes over the world and Elon becomes our collective benevolent dictator.
- PEAK AUTO! Perhaps we are in the USA, maybe we are in EU, I doubt we are in China – which happens to be the largest market in the world (28 million cars sold this year).
- Perhaps lending has gotten too loose since their last great stress test and the next downturn unveils some ugly NPL’s turning to sour loans.
- They make some big capital allocation mistake. Their purchase of Rolls Royce and of Land Rovers brands (then subsequent sale of everything but Mini) has proved to be okay, though future capital allocation be not so.
All said, BMW looks like a value. It’s priced today as if a recession is coming and a recovery will be non-existent. That could be true, though the market isn’t pricing recession anywhere else. I don’t think the business, its assets, the distribution network, and brand can be replicated with €49 billion (the cost today). Buying the preferred shares at €74 means you’re paying book value and 6.3x trailing twelve months earnings. Though that multiple might be reasonable for cyclical near the end of a cycle, it doesn’t show the true value of the parts and in particular the bank. The shares also pay a dividend just a tad over 4.5%.
It’s a business I understand, one that’s proven difficult to kill, will likely create more value over the next decade than it is today (and has the balance sheet strength to do it), has a brand value that has proven a competitive advantage, produces high-quality products, and has a management team that’s competent and efficient.
With that said, I see no hard catalyst for a multiple re-rating in sight and it’s definitely not early innings in the cycle. It’s also a business that has very high fixed costs so incremental unit growth is incredibly important (it’s not easy to simply shrink the expense base of the business if end markets slow considerably). If you like watching daily stock prices, and can’t look out over the next decade (vs a year or two), this is probably not one for you.
The annual report is one of the few I actually find interesting for petrolheads.
***As is forever and always the disclaimer, this is not investment advice. Do your own work and verify your own numbers. I might buy, sell, or ignore anything at any time and have no obligation to update anything on this site.***