EUR 850.00 For Business Accounts Only

Morningstar | BMW Cuts 2018 Guidance on Confluence of Headwinds; Maintaining EUR 117 FVE

Narrow-moat BMW, maker of premium brand BMW cars and motorcycles, Mini, and Rolls-Royce, cut 2018 guidance because of a confluence of several items affecting revenue and margin, including negative currency effect, upfront investment in future mobility technologies, Europe market distortions on new emissions testing regulations, higher warranty reserves, and international trade conflicts. We had already been using assumptions at the low end of management guidance, which resulted in only a slight change to our estimates. The market reacted harshly to the guidance cut, taking the shares down by a cumulative 6% since the announcement.

BMW does not provide specific numbers, but management had previously guided to "slight" increases in automotive units and revenue with EBIT margin of 8%-10%. Automotive segment revenue is now forecast to be "slightly lower than the previous year," owing to negative currency effect and the price pressure experienced in Europe and in China (tariffs). EBIT margin guidance is now "at least 7%" on higher spending for electrification and autonomous technologies, plus significantly higher additions to goodwill and warranty provisions.

We had been forecasting 3.8% revenue growth on a 5% currency headwind and an 8.0% EBIT margin. We now forecast a 0.9% decline in revenue on the same 4.9% currency headwind, with an EBIT margin of 7.7%. However, we had already been forecasting sub-8% EBIT margins in years two to five of our Stage I forecast. Consequently, there is no change to our EUR 117 fair value estimate. In our opinion, the shares were already unfairly discounted by the market prior to the guidance change. Investors should view any additional sell-off of the 4-star-rated BMW shares as a window of opportunity to own an attractively valued, narrow-moat company.

In Europe, beginning Sept. 1, all new vehicles sold must be certified under the World Harmonised Light Vehicle Test Procedure. BMW was ready in advance of competitors for the new test that seeks to emulate real-world driving conditions. However, many competitors' models were not certified by the deadline. Consequently, consumers bought vehicles in anticipation of the change, driving European light vehicle demand up by 9% in July and 28% higher in August versus the respective year-ago periods. Availability of certain models in Europe has dropped dramatically as some models still await certification. As a result, competitors have discounted certain models to spur demand. While BMW will need to be competitive in the market, since the company has already completed all certifications, we think availability of BMW models will be an advantage.

In the Chinese market, BMW imports several cross-over 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. 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 25% tariff increase. In our view, even though Chinese consumers are more price sensitive, most of those who would have had the means to purchase the more expensive models will not be turned away by the modest increase as these consumers seek status symbol products.

Our fair value estimate represents a 32% discount to the current market valuation and 27% upside potential to the consensus price target. We think BMW's stock has been overly discounted on concerns regarding an escalation in tariffs, the diesel antitrust investigation, the U.S. demand cycle, and the impact of international trade conflict.

During the past 10 years, BMW's group EBIT margin has had a high, low, and median of 11.6%, negative 0.6%, and 9.0%, respectively. We assume a 7.7% normalized sustainable midcycle group EBIT margin, 30 basis points below management's long-term 8%-10% guidance and 130 basis points below the 10-year median. For our model to generate a $92 fair value, equivalent to the sell-side consensus price target, investors would have to believe that BMW's normalized sustainable midcycle EBIT margin would be 6.1%. At the current market valuation of EUR 79, our normalized sustainable midcycle assumption would have to be 4.6% for our model to generate an equivalent fair value. In our view, the market has unfairly valued BMW as though fundamentals will only deteriorate from the current transitory pricing environment and increased spending on industry disruptive technologies.