Investors often shun the automotive industry for ideas because of its highly competitive nature and steep capital costs. However, there are competitive advantages – or moats – in the sector if one knows where to look, particularly among suppliers that boast solid brand intangible assets such as Italy’s Ferrari (RACE). The absence of a moat does not rule a stock out as an actionable idea: Morningstar equity analysts think no-moat Volkswagen (VOW) offers compelling value despite the diesel emissions scandal. Narrow-moat BMW (BMW) also looks cheap.
We forecast 2018 global light vehicle demand to increase by 1%-3%: the European recovery will continue with a 2%-4% increase, and India demand will rise by a robust 9%-11% in 2018. But China demand growth will slow in 2018 to 1%-3% as a consumption tax hike on small engine passenger vehicles takes effect.
Even though the car is a modern-day technological marvel that requires enormous engineering talent, complex software coding, and immense organisational skill to design, develop, and bring to market, substantial global industry overcapacity reflects the paucity of barriers to entry, despite substantial capital requirements. In price-conscious, high-volume markets, fickle consumers can switch among competing brands, and quite often, they do. The latest fads, high-profile recalls, reliability ratings and the low cost of financing can all influence consumers' buying decisions.
Nevertheless, some carmakers have managed to demonstrate evidence of sustainable competitive advantages and generate profits way above the cost of capital.
Ferrari is a Luxury Company
Ferrari's wide moat rating flows from its ultra-exclusive brand developed from decades of successful and formative participation in Formula One racing; and we describe Ferrari as a luxury company rather than a mere carmaker. This enables substantial pricing power that drives revenue growth, generates wide margins, and creates sustainable economic profitability. Categorising Ferrari as an automotive company implies a lack of pricing power and capital intensity, resulting in low margins and returns as well as volatile financial results — none of which appears in Ferrari's performance. Even though at times, we are willing to pay up for wide-moat rated companies, Ferrari trades at one star, a valuation that is as rich as its Formula One racing heritage.
BMW continues to outperform the worldwide light vehicle market despite global economic uncertainties and is one of only a handful of carmakers to which we have assigned an economic moat, albeit a narrow one. The company's shares have been discounted after the diesel scandal and fears the company will experience higher costs in the move towards electric vehicles in Europe. This four-star-rated stock currently trades at a 20% 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.
We have assigned a no-moat rating to Volkswagen on relatively low economic profitability. Strong brands in the group's roster that command premium pricing like Audi, Bentley, Bugatti, Lamborghini, and Porsche, have the potential to generate competitive returns on capital if rated separately from the group results of Volkswagen. However, these returns are diluted across mass-market brands like Volkswagen, SEAT, and Skoda. With VW such a dominant manufacturer in Europe, the shift to electric production will harm profit margins in coming years.
Fallen from the favour it once enjoyed among investors before the diesel crisis, Volkswagen stock remains at a discount for the diesel emission test cheating and for an EC anti-trust investigation.
Electric Future Will Take Time
2017 announcements by the UK and France banning petrol and diesel cars from 2040 show that governments are moving toward a zero emission world; but we caution investors not to get carried away with the media's enthusiasm nor assume that we will all be driving pure electric cars any time soon.
The devil is in the details on these announcements in our view, and there is a difference between an all-electric vehicle (BEV) and an electrified vehicle. This does not mean all of Europe will be driving BEVs exclusively in 2040 as it leaves the door open for hybrids, which will still be manufactured after this date.
The high media profile of Tesla (TSLA) has helped spur enthusiasm for electric vehicles. By our estimate, Tesla is likely to reach its 200,000th car sold in the US by 2019, helped by tax credits. But the tax credit for a Tesla is not the main reason people buy one — we think they buy one because they love the product, love Elon Musk, and love his mission of moving the world to sustainable electric transport.
