EUR 850.00 For Business Accounts Only

Morningstar | Continental Reports Solid 2Q Results, New Technology Spending Up; EUR 153 FVE Unchanged

Narrow-moat-rated Continental announced second-quarter earnings per share before special items, or EPS, of EUR 4.28, a solid EUR 0.43 better than the EUR 3.85 consensus EPS and EUR 0.44 higher than the prior year's EUR 3.84 EPS. The outperformance relative to the consensus expectations were driven by SG&A leverage and manufacturing efficiencies. Revenue increased 3% to EUR 11.4 billion. Excluding negative currency translation, revenue would have increased 5%. At EUR 1.161 billion, consolidated adjusted EBIT declined 5% from EUR 1.216 billion as margin contraction hit all segments except for the ContiTech group. In addition to negative currency effects and higher tire group inventory valuation effects, R&D spending increased to 7.6% of revenue, 40 basis points higher than the second quarter of 2017. Consequently, consolidated adjusted EBIT margin slipped 80 basis points to 10.2% compared with 11.0% in the second quarter of 2017. The 2-star-rated shares of Continental currently trade at a 22% premium to our unchanged EUR 153 fair value estimate.

Guidance for 2018 includes higher raw material cost (negative EUR 50 million), spending on tire capacity expansion, and costs associated with a greenfield tire facility in Thailand, and lower third-quarter European customer production on the new more complex emission certification process. Management confirmed guidance but said that the EUR 50 million negative impact from raw material cost was incurred in the first half and that second half's raw material cost should be neutral. Unfavorable currency translation and negative inventory valuation effects on the tire business are an additional EUR 150 million headwind for the year, resulting in 2018 adjusted margin guidance of more than 10%, down from 10.9% last year.

Automotive group revenue rose 5% on a 10% increase from the interiors division, a 4% increase in the powertrain group and a 1% increase in the chassis & safety division. Excluding negative currency impact, automotive group revenue would have risen by a healthy 7%. Automotive group adjusted EBIT margin declined slightly by 30 basis points to 8.0%. While the interiors group margin held constant at 9.0%, powertrain and chassis & safety margins contracted 40-basis points each to 5.7% and 8.9%, respectively, owing to increased new technology spending.

Rubber group revenue, down 1%, was impacted by unfavorable currency translation and softer tire sales versus a difficult comparison from the second quarter of 2017, disappointing due to the tire group's efforts to improve product mix and general tire price increases last year for higher rubber costs. With a 3% increase from the industrial ContiTech division, the tire division was more than offset for a 3% total increase in rubber group revenue. Excluding the negative currency impact, rubber group revenue would increased 5% year over year.

Rubber group adjusted EBIT margin also suffered moderate contraction but improved sequentially from the first quarter. A 70-basis point drop in tire group to 17.8% adjusted EBIT margin compared with 18.5% reported last year, was partially offset by a 60-basis point expansion to 8.2% for the ContiTech group. Rubber group adjusted EBIT margin was 14.3%, down 20-basis points compared with the second quarter of 2017. Even so, versus the first quarter of 2018, Rubber group adjusted EBIT margin expanded 170-basis points as inventory valuation effects tailed-off in the second quarter.

The sell-side remains infatuated with Continental's growth potential from autonomy and vehicle electrification. Share valuation has also been driven higher on the IPO of the powertrain operating group by mid-2019. While we agree with the market that Continental will benefit from healthy growth in vehicular autonomous technologies and electrification, we disagree with the sell-side's valuation. However, since March of this year, the consensus price target has declined 6% while the stock price dropped 15% during the same time frame.

In our opinion, the sell-side values Continental shares as though revenue growth and margin expansion will continue in perpetuity. We forecast average annual revenue growth of 8% through the mid-point of our five-year stage I forecast before tapering-off revenue into our midcycle assumptions in year four and five. During the past 10 years, the adjusted EBIT margin high and low has been 11.9% (2015) and 4.2% (2009) with a median of 10.1%. We have assumed a midcycle normalized sustainable adjusted EBIT margin of 10.2%, 10-basis points above the 10-year historical median of 10.1% but 20-basis points higher than management's margin guidance of 10.0% in 2018. For our DCF model to generate a fair value estimate equivalent to the market’s current consensus price target of EUR 235, investors would have to believe that Continental's midcycle normalized sustainable adjusted EBIT margin is 15.3%, 260 basis points in excess of the 10-year high and 420 basis points higher than the 10-year median. In our opinion, the sell-side values Continental stock as though economic cycles are extinct.