Market Misses Daimler's Operational Strength

We think the market reaction to Daimler's third-quarter results missed the underlying strength of the operations, excluding special items. Including charges of EUR 223 million for a diesel recall and EUR 230 million for a recall related to Takata airbags in the Mercedes car group, plus a EUR 70 million restructuring charge in the truck group, as-reported EPS came in at EUR 2.03. Daimler’s shares are undervalued, in our view, relative to our estimates for future cash flow and returns on invested capital.

Daimler's highly regarded Mercedes-Benz brand is one of the top luxury automobile names in the world, while Freightliner is the leading Class 8 truck brand in the United States. Daimler holds a 15% stake in Russian truckmaker Kamaz, makes ultrasmall Smart cars, and is a European leader in buses and vans.

Despite reputable luxury car and heavy truck brands, Daimler faces stiff competition in all of its markets. The company operates in a cyclical, capital-intensive industry where raw material commodity costs can be volatile and unionized labor can be expensive. Consequently, economic profitability has not been consistent.

Geographically diverse sales reduce exposure to the economic conditions of any one region. Even so, premium brands such as Mercedes limit carmakers' exposure to downturns suffered by mass-market auto companies because wealthier customers are less concerned about funding a vehicle purchase during a recession.

New product is critical to spurring consumer interest and can help results even in an economic downturn, as the introduction of a new E Class did for Daimler during 2009 and 2010. Mercedes-Benz launches new or significantly refreshed models in various markets around the world every year.

Research and development spending is substantial, averaging more than 5% of sales, which we view as a necessary part of a long-term strategy. Environmental legislation worldwide will force automakers to design more efficient combustion and zero-emission vehicles. While development costs are high, Daimler needs leading technologies--like lithium-ion batteries for hybrid and electric cars--to preserve its reputation as an innovator.

Over the long term, we think Daimler has the potential to be one of the most profitable automakers. However, this potential is constrained by stiff competition from global luxury players BMW, which also owns Rolls-Royce, plus Audi and Bentley, which are owned by Volkswagen. Even though capital intensity, competition, and cyclicality are high for automobile manufacturers, these negatives are more pronounced for medium- and heavy-duty commercial truckmakers, constraining Daimler's potential to acquire an economic moat.

Not Even Mercedes Can Drive a Moat Although the Mercedes-Benz brand is a luxury vehicle icon, we rate Daimler as having no economic moat, as is the case for most automobile manufacturers. Switching costs for consumers is low, as customers have several brands from which to choose when considering a luxury vehicle, including names such as BMW, Audi, Lexus, and these days in the U.S., even Cadillac.

While there may be some who are loyal to a particular brand, these products are easily substituted by wealthy customers. Furthermore, it is equally difficult to envisage economic profits 10 years from now in the highly competitive, intensely cyclical heavy truck, commercial van, and bus business in which Daimler participates.

The auto manufacturing business is capital-intensive and cyclical, which makes generating economic profits more difficult. Globally, auto industry overcapacity is about 20 million units and growing. Many countries support their domestic automakers in an effort to create jobs and spur economic activity. The entrance of emerging-market firms such as Bajaj (India), Tata (India), Chery (China), and Geely (China) demonstrates government support of domestic markets.

Owing to increasing global capacity, existing industry players will find moat-building very challenging. Forecast bias is rampant among auto manufacturers. Each carmaker builds capacity based on its expectations for future demand growth and its sanguine beliefs in achieving certain market share objectives. However, if it were possible to accumulate each company's share expectations, the totals would add to more than 100%.

Operating Leverage Can Cause Profit Swings Daimler operates in a fiercely competitive, highly cyclical, capital-intensive industry. The company's fixed costs create unfavorable operating leverage that can cause profits to swing widely in response to relatively small changes in demand.

Commercial heavy truck, van, and bus demand has even more volatile swings in demand than passenger cars. The capital intensity is also relatively higher considering the much lower production volume. Obviously, medium- and heavy-duty commercial truck pricing is vastly different than the passenger vehicle market. But even with pricing that exceeds EUR 100,000, Daimler's commercial vehicle business lacks consistency in economic profits.

Commodities can inject cost volatility, buffered by long-term contracts, that have a material impact on profitability and returns. Tough German labor unions, in conjunction with political sympathy for domestic labor, could make it difficult for the company to rationalize capacity in its home market, if management should find it necessary.

We consider Daimler's balance sheet to be in good shape. The company maintains a substantial cash balance and healthy availability on bank lines of credit. To remain competitive, automakers need high liquidity to fund R&D and capital investment to support product launches throughout economic cycles. Given that European auto demand is in recovery, we expect Daimler to average relatively higher free cash flow over our five-year explicit forecast period, which should support an improvement in dividend payouts to shareholders.