EUR 850.00 For Business Accounts Only

Morningstar | CON Updated Forecasts and Estimates from 18 Sep 2018

Narrow-moat rated Continental announced that it cut its 2018 guidance due to weaker-than-expected automaker customer production schedules in Europe and China, softer tire sales, higher-than-anticipated warranty expense, higher cost for hybrid powertrain launch, and launch cost in the industrial ContiTech group. Revenue guidance was reduced by EUR 500 million in the automotive group and by another EUR 500 million in the tire group. Consolidated 2018 revenue is now expected be around EUR 45 billion, including management's expectations for negative currency effect.

Adjusted EBIT margin guidance for 2018 had been more than 10% but was reduced to more than 9%. In addition to higher expense from warranty and hybrid powertrain, management said that record order intake of EUR 20 billion in the first half of 2018 resulted in higher than expected development costs. Higher order intake this year bodes well for revenue growth after 2019. Lower guidance for 2018 revenue and margin resulted in free cash flow guidance being chopped by EUR 400 million to EUR 1.6 billion from EUR 2.0 billion.

We originally initiated coverage on Continental with a 4-star rating in early 2013. After which, the stock steadily climbed until trading in the 1-star range in 2014. Since then, the stock has traded mostly in the 2-star range but spent most of early 2018 in 1-star range. From a EUR 251.70 high in January this year, the stock is down 36% including the 13% plunge on the guidance news. At EUR 153, our fair value estimate was already well below the market. Now trading at 3-stars and a 5% premium to our fair value estimate, we view the shares of Continental as reasonably valued relative to our forecasts for revenue growth, free cash flow, and returns on invested capital. If shares weaken further as sell-side analysts adjust estimates and price targets, we think the stock would become attractively valued below EUR 130 in the 4-star range.

In our view, the confluence of events that led to management's guidance cut are transitory in nature and company specific. We think automotive group revenue has been impacted by tougher European emission certification that has reduced European automaker output as well as Continental's exposure to slower selling sedan vehicle programs in China where SUVs are enjoying greater popularity. The company did not provide any details about its warranty issue (customer, model) other than an incremental EUR 150 million in expense above management's previous forecast.

We fault management for not adequately preparing manufacturing processes for the launch of more complex hybrid powertrain systems. In an industry that demands annual contractual price declines and world class lean manufacturing techniques like Kaizan, Kanban, and Six Sigma as the price of entry, important launches of industry disruptive technologies like hybrids should have been well understood prior to job 1.

Despite the issues faced by Continental in the second half of 2018, we saw nothing in the company’s revised guidance that would cause us to change our normalized sustainable midcycle assumptions which weigh much more heavily on our fair value estimates than the first- and second-year estimates in our five-year Stage I forecast. If anything, record order intake in the first half of 2018 gives us greater confidence in our midcycle assumptions. During the past 10 years, Continental's high, low, and median adjusted EBIT margin has been 11.9%, 4.2%, and 10.1%, respectively. At 10.2% adjusted EBIT margin, our midcycle assumption is nearly in line with the 10-year median.