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BMW's Strong Brands Drive a Narrow Moat

We think the automaker is undervalued.

Given the global strength of BMW’s BMWYY brands, including passenger vehicles, motorcycles, Mini, and Rolls-Royce, in addition to leading powertrain technology and consistent excess returns, we assign the company a narrow economic moat rating. Unlike its direct compatriot competitors, Audi and Mercedes-Benz, it doesn’t see its consolidated intangible asset moat sources diminished by other no-moat businesses like commercial truck and mass-market brands. BMW has generated returns on invested capital above its weighted average cost of capital in 10 of the past 12 years. In eight of those years, returns were greater than 5 percentage points above WACC. We view BMW shares as undervalued relative to our forecast revenue and cash flow.

The Evidence for BMW's Narrow Moat Because of the strength of intangible assets, including brand and intellectual property, BMW has a narrow moat rating. Brand strength has enabled premium pricing across all of BMW's products, while intellectual property supports the brand image with strong product execution, especially in powertrain.

BMW continues to outperform the worldwide light-vehicle market despite global economic uncertainties and is one of only a handful of automakers to which we assign an economic moat, albeit a narrow one. Since the Great Recession in 2009, worldwide light-vehicle registrations have grown at an average annual rate of 5%; this compared with BMW volume (including China joint venture) growth of 9% during the same period. As emerging-market consumers become wealthier, many will purchase more luxury items. Given the aspirational nature inherent in BMW’s brands, as well as the growth potential from increasing wealth in developing markets, we believe the company will continue to reward investors with solid returns.

Considering the strength and global recognition of the company’s brands, technological leadership in powertrain, the ability to command premium pricing from consumers who regularly rate its vehicles as one of the best to own, and the ability to consistently generate excess returns, we assign a narrow moat rating to BMW. Even though the venerable Rolls-Royce and BMW brand names command premium pricing, consumers can easily switch to other brands like Bentley, Mercedes-Benz, or Audi, and a seemingly bulletproof brand image can tarnish quickly. However, owing to an ingrained culture that obsesses over the details that the company’s customers demand, we think BMW will continue to successfully manage its brand images, ranging from premium-priced BMW motorcycles and Mini Cooper passenger cars to luxury BMW passenger cars and crossovers to ultraluxury Rolls-Royce cars, leading to economic value creation for investors.

The company has won numerous industry accolades and awards year after year that demonstrate its ability to consistently produce vehicles that consumers aspire to drive. Since 1983, the BMW 3 Series has appeared 22 times on the Car & Driver 10 Best Cars list, second only to the Honda Accord at 33 times (the Chevrolet Corvette was third at 20). Since 1995, BMW engines have consistently been included in the Wards Automotive 10 Best Engines list. Over the past 10 years, BMW was repeatedly counted among the top five in J.D. Power’s APEAL Study.

BMW Group engines have been included in the Wards 10 Best Engines list more than any other automaker, appearing 36 times since Wards began compiling the list in 1995. To be eligible for the competition, engines must be all new or improved and available in a regular-production, U.S.-specification model during the first quarter of the year of the list. Each year, there is a certain price cap for vehicles to be included, so high-end and exotic sports cars are excluded. Wards Automotive says its editors drive the vehicles in their routine commutes during October and November and score each based on power, technology, refinement, and observed fuel economy. The frequency and longevity with which BMW engines have appeared in the 10 Best Engines list demonstrates the company’s ability to regularly innovate to maintain its leadership in automotive powertrain technology.

J.D. Power’s Automotive Performance, Execution, and Layout, or APEAL, Study examines what consumers like or dislike about their new vehicles after 90 days of ownership. Since 2003, BMW brand vehicles have scored in the top five of all makes in the survey a total of 14 times, second only to Porsche. The APEAL Study examines how gratifying a new vehicle is to own and drive, based on owner evaluations of more than 80 vehicle attributes. These 80 attributes fall into one of eight categories of vehicle performance and design: engine/transmission; ride, handling, and braking; comfort and convenience; seats; cockpit and instrument panel; heating, ventilation, and cooling; sound system; and styling and exterior. BMW’s repeated appearance in the top five of the APEAL Study indicates consistently well-executed vehicles that solidly connect with the customer base.

Economic Profit: The Telltale Sign of a Moat BMW's focus on ultraluxury, luxury, and premium segments, with an obsessive attention to detail, has enabled substantial excess returns over its weighted average cost of capital. Since 2006, the company has created economic value in 10 out of the 12 years by an average of 6.7 percentage points, an outstanding performance for an automotive manufacturer.

Unlike its competitors, BMW’s consolidated intangible asset moat sources are not diminished by other no-moat businesses like commercial truck and mass-market brands. While brands like Audi, Mercedes-Benz, and Porsche may have a moat, the consolidated economic profit of the parent--Daimler DDAIF for Mercedes and Volkswagen VWAGY/VWAPY for Audi and Porsche--has average economic profit of 2 percentage points or less during the past 10 years. In our view, at 7 percentage points of economic profit, it is more likely than not that BMW will generate economic profit for the next 10 years, Morningstar’s definition of a narrow economic moat. At 2 percentage points or less of average economic profit during the same time frame, we cannot say the same for most competitors, resulting in no-moat ratings.

BMW's Compelling Valuation We think shares of narrow-moat-rated BMW have been discounted on fears that the company will be fined for collusion and experience margin degradation on higher spending to develop electrified powertrain and autonomous driving technologies as well as concerns regarding its diesel exposure in Europe and international trade conflict. This 4-star-rated stock currently trades at a 38% discount to our fair value estimate. In our opinion, long-term investors have an opportunity to own BMW at an attractive valuation relative to our forecast of future cash flow and returns on invested capital.

BMW has been able to consistently produce vehicles that command superior pricing as well as margin and to generate volume increases above global vehicle growth rates. For example, under its Strategy Number ONE plan initiated in 2007, management set a 2020 goal of annually selling more than 2 million vehicles but had already surpassed the volume objective by 2014. BMW also set a goal to achieve an automotive segment return on capital employed (roughly equivalent to Morningstar’s calculation of return on invested capital) of 26%, which translates into an EBIT margin of 8%-10%, excluding China joint venture equity income and financial services.

Near-Term Margin Pressure The company has achieved a 10-year historical median EBIT margin of 9.0%, already well in range of its 2020 objectives. In 2017, EBIT margin was 8.9%, and we estimate 2018 EBIT margin of 6.7% for the harsh pricing environment in Europe due to the worldwide harmonized light-vehicle test procedure, or WLTP, and world trade conflict such as U.S. steel and aluminum tariffs and China placing a 40% tariff on vehicles imported from the United States. Several European manufacturers had many models that were not WLTP-compliant at implementation on Sept. 1. Consequently, automakers put hefty incentives on models that were compliant. Because BMW was nearly 100% compliant at implementation, BMW models were more readily available on dealership floors. In September, BMW reported that in Germany, sales were down 11.3% while Daimler and Volkswagen reported sales declines of 16.7% and 45.2%, respectively.

World trade tensions have had approximately a EUR 300 million impact on BMW from higher raw material costs, including for steel and aluminum. In the Chinese market, BMW imports several crossover models from the U.S. However, the X3, its most popular model in the Chinese market, launched local production at the end of the second quarter of 2018. We expect pricing on the X3 to be slightly more attractive as a result. Even though the company raised prices on the more expensive X5 and X6 models by 4%-7%, the increase was not commensurate with the additional 25% tariff on U.S. imported vehicles, incremental to the base 15% tariff on all imported vehicles. In our view, even though Chinese consumers are more price-sensitive, most of those who have the means to purchase the more expensive models will not be deterred by the modest 4%-7% increase as these consumers seek status symbol products. However, if recent media reports are true, the additional 25% tariffs on vehicles imported from the U.S. may be eliminated soon, putting BMW’s U.S. imported X models at the same tariff level as all other imports.

Industry-Disruptive Technologies Factored In Our fair value estimate already includes expectations for margin pressure from electrification and autonomous driving technologies. BMW plans to offer traditional and electrified powertrains for all models by 2020. In 2025, the company targets a portfolio of 25 models: 12 all electric and 13 with hybrid options. BMW differentiates itself, with its highly focused attention to powertrain intellectual property, by retaining in-house development and manufacturing of electrified powertrain with the only exception being the battery cells. Most competitors have opted to outsource most of the electrified powertrain to suppliers. Management also plans to offer its models with the option of any powertrain the customer wants--traditional internal combustion, hybrid, or battery electric. Most competitors have decided to develop platform-specific battery electric models. While we recognize the engineering challenges and cost in BMW's approach in the near term, we think the strategy will pay off in the long run with greater economies of scale sooner than automakers that develop battery electric-specific platforms.

BMW has shared the development burden of autonomous technologies across several partners including HERE, Lyft, Intel Mobileye, Aptiv, Magna, Continental, and Fiat Chrysler. According to management, there is strong interest from other automakers and ride-hailing companies to partner for development. Forward collision warning, automated emergency braking, and lane-departure warning are already offered as standard or optional equipment on nearly every model. By 2021, BMW plans to offer highly automated driving, or Level 4 (out of 0-5 levels), as standard or optional equipment on all its models.

Despite management’s objective to maintain industrial EBIT margin within an 8%-10% range, we assume average EBIT margin at 7.0% during our five-year Stage I forecast for the development of industry-disruptive technologies. Our profit assumption represents a significant discount to the historical high of 11.6% and 10-year median of 9.0%. Our 7.7% midcycle EBIT margin represents a 130-basis-point discount to the historical 10-year median.

Potential Impact of Diesel Equipment Collusion With respect to diesel antitrust investigations of German automakers, for BMW a fine of EUR 700 million would result in a 1% reduction in our EUR 117 fair value estimate. Assuming our estimated worst-case fine of EUR 9.9 billion (10% of consolidated revenue) in the event the European Commission finds that BMW colluded, our fair value estimate would drop to EUR 100 from EUR 117. If our fair value estimate were EUR 100, the stock would be currently trading at a 27% discount to our fair value estimate. Consequently, we think the stock's upside opportunity outweighs the downside risk. We also note that the worst-case antitrust outcome scenario did not include any of the EC's potential "mitigating, leniency, or settlement" factors, which would reduce the fine.

Declining European Diesel Demand We think declining diesel demand in Europe has limited to no impact on BMW profitability. We compared BMW's passenger car diesel engine penetration with its industrial EBIT margin. While the correlation was 0.13 for 2001-17, the relationship was stronger from 2011-17. However, during that latter time frame, at 0.60, the correlation was still statistically weak with a p-value of 0.16. We think most of the margin impact is related to spending on industry-disruptive technologies, but profitability has still been above our forecast range. In our opinion, BMW has had no profit impact from transitioning to gasoline-powered cars since diesel penetration began to decline in 2015.

In the long term, declining diesel engine demand will increase the risk of capacity impairment. Even so, BMW’s electrification strategy will require capacity because the company plans to insource production of electric powertrain compared with most manufacturers, which plan to outsource most of an electric powertrain. Given the company’s electrification plans through 2025, we think that capacity transition will be costly but orderly, and the risk of substantial asset impairment is overly discounted in the stock’s current valuation.

U.S. Tariff Potential Impact We estimate that the impact to BMW due to a 25% U.S. tariff on imported vehicles would result in a 12% decline in U.S. volume, assuming a 25% price increase on all U.S. imported BMW models. However, this would result in only a 1.7% slip in global BMW volume. The revenue impact would be a decline of 2% while we estimate a 4% reduction in profitability or roughly 0.3 percentage point of industrial EBIT margin.

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