BMW Hold / Daimler Sell / Volkswagen Sell / Renault Hold / PSA Sell / FCA Hold / GM Sell / Ford Sell
● The cycle starts to unwind: An automotive cycle that until 2017 was lifted by a
combination of cheap credit, cost deflation, underinvestment, and currency
tailwinds is by all appearances drawing to a close. In 2018, the first signals that
these factors are softening or reversing have become more apparent, leading to a
series of downwards adjustments to guidance by a number of OEMs. While the
blame for this year’s setback has been laid at external and temporary drivers like
tariffs and emissions testing, more concerning realities exist beneath this
narrative, such as contracting margins in once highly profitable markets and
products, and sharply deteriorating cash flows that in some cases already fail to
cover dividend payments. The danger for companies caught in these headwinds
is due to their willingness to place the blame on extraordinary factors, and
ignore the greater risks from the steady removal of the cyclical tailwinds that
have supported the industry for nearly a decade.
● Cash flow the key concern: The industry’s cash margins, which take into
account investments made, fell from 3.1% in 2015 to 2.7% in 2017. That decline
has been most pronounced at premium OEMs, where it declined from 5.1% to
3.6%, while the mass market has seen cash margins remain stable at c2.5%. This
divergence can be largely attributed to a sizeable increase in investments at
premium OEMs, while the mass market has instead focused on delivering shortterm
earnings and cash flows rather than investing in future technology. The
cash flow risk will come from two directions. Firstly, this year will be the first
year since 2012 that the industry will likely see a yoy earnings decline, based on
our estimates (H1 is already down c12% yoy). Secondly, investments committed
to products like EVs and emissions reduction may not be easily pared as
technology disruption increases and the distance to CO2 targets fails to narrow.
Additional risk for mass market OEMs likely comes from a potential reversal of
their constantly growing negative working capital positions over the past few
years.
● Compressing financing margins: A widening retail financing margin has been a
key driver for growing volumes, as it enabled financial services businesses
(fincos) to expand the balance sheets at a fast pace. In Europe, refinancing rates
for automotive fincos have stayed at the same low level for the past two years,
but financing margins have already begun to compress. In our view, this is an
indication that price pressure is taking a stronger hold on the market, as OEMs
struggle to avoid rising incentivisation. It follows a similar trajectory to the US,
where OEMs like Ford have already exhibited significant financing margin
compression as higher refinancing costs could not be passed on to consumers.
Such a compression reduces the ability to expand assets and support industrial
growth.
● Labour cost inflation another late-cycle headwind: Moderate labour cost
inflation of 2-3% pa between 2014 and 2017 was significantly below the c6% pa
sales growth, which provided margin support. However, labour cost inflation in
key producing countries like Germany (up 8% from January to May) or the US (up
4% from January to June) has materially accelerated in 2018, while sales growth
for European OEMs slowed to just c1% in H1 2018. Like raw materials, labour cost
inflation is another late-cycle headwind, which will weigh on profits and
margins in a more meaningful way in the coming quarters.
● Earnings and cash flow risks underestimated: After multiple years of solid
earnings growth and margin expansion, the sector is likely to head into a
prolonged period of earnings downgrades, as the up-cycle is gradually
unwinding. The market likely underestimated the magnitude of cyclical
tailwinds since 2010 and will probably underestimate the deterioration of the
same factors. We see little reason to become more constructive on the sector, as
the de-rating is set to accelerate once shareholder return support fades.