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Brexit roadblock: Will wheels fall off for auto stocks?

Lex Hall  |  24 Oct 2019Text size  Decrease  Increase  |  
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Fears of a no-deal Brexit present no barrier to automotive stocks, some of which have been heavily discounted, says Morningstar analyst Richard Hilgert.

German carmaker BMW remains the pick of the bunch and is trading at a 36 per cent to Hilgert’s fair value estimate of €105 ($107).

Among other actionable ideas in Hilgert’s latest report on the effect of a worst-case Brexit scenario on the auto sector is American car parts supplier Tenneco.

The five-star, narrow-moat company is trading at an 82 per cent discount to Morningstar’s fair value estimate of US$73 ($107).

Despite ructions in the UK parliament over Britain’s push to seal its divorce from the EU, Hilgert says his valuations on auto stocks remain unchanged.

“Even though our worst-case scenario includes recessionary light-vehicle demand, and even though the UK and EU automobile industry is highly integrated, a no-deal Brexit does not change our normalised, sustainable, midcycle assumptions,” Hilgert says in his report, Brakes-It: Worst-Case Brexit Implications for Autos.

“The auto sector has historically adapted to geopolitical issues, adjusting capacity and supply chains to optimise returns in the long run. Even so, we think the market has overly discounted some auto stocks relative to our worst-case scenario, resulting in select investment opportunities.”

British politicians on Tuesday rejected the government's timetable to fast-track legislation for its deal to take Britain out of the European Union.

Boris Johnson behind wheel of car

British Prime Minister Boris Johnson. A new election is tipped as the only way to move on from the Brexit crisis if the European Union agrees to a delay until January

The defeat in parliament means Britain will not be able to finalise its exit by Prime Minister Boris Johnson's October 31 deadline.

The next step, Johnson said, would be waiting for the EU to respond to a request to delay the deadline, which the prime minister reluctantly sent to Brussels on Saturday after being forced to do so by politicians.

A source in Johnson's office told Reuters that a new election is the only way to move on from Britain's Brexit crisis if the European Union agrees to a delay until January.

Wheels of commerce turn between Britain and the EU

The UK automotive industry is highly integrated with the EU, including both vehicle production and parts manufacturing, Hilgert notes.

Germany is the top destination for UK auto exports; while, the UK is the No 2 destination for German auto exports.

Hilgert also notes that according to The Society of Motor Manufacturers, the average price of a UK-built vehicle sold in the EU would increase £2800 ($5266) while the price of an EU-built vehicle sold in the UK would increase £1700 on average.

“Given the degree of integration between the UK and EU, the substantial amount of capital at risk of impairment both in the UK and the EU, plus Germany’s influence in the EU parliament, we think at least a trade agreement on the automotive sector would be rational, but we have not claimed politicians are rational.”

The outcome of Brexit is not the only factor affecting valuations, Hilgert says. Other macroeconomic factors weighing on forecasts include:

  • The ongoing US-China trade war
  • Spending on disruptive technologies such as powertrain electrification
  • Falling diesel demand in Europe
  • Antitrust charges against German carmakers
  • Weak demand in China
  • Softening demand in the US

Actionable ideas that retain 4- or 5-star ratings in a no-deal Brexit scenario

Here is a list of eight actionable ideas in the automotive sector, with some commentary from Hilgert.

BMW

“BMW’s narrow moat rating is derived from intangible assets, including brand and intellectual property in powertrain. The company’s moat has supported an average of 7 percentage points of economic profit over the past 10 years. Shares trade at a 43 per cent discount to our fair value.

Clouds over BMW building

BMW’s narrow moat rating is derived from intangible assets, including brand and intellectual property in powertrain, says Morningstar's Richard Hilgert

“We think the market has priced BMW as though industry-disruptive technology spending will permanently leave margins at cycle lows, a view we do not share owing to the company’s narrow-moat driven by premium brands across the entire product portfolio.”

“The company continues to guide to a long-term 8 per cent to 10 per cent industrial EBIT margin range with 6 per cent to 8 per cent for 2019, excluding a charge for the European Commission's finding that German automakers colluded on diesel equipment (4.5 per cent to 6.5 per cent including the charge).

BorgWarner

Narrow-moat BorgWarner's 4-star-rated stock trades at a 33 per cent discount to Hilgert’s fair value estimate.

“We think BorgWarner's economic moat sources derived from powertrain intellectual property and switching costs are misunderstood. The market, in our view, has valued shares as though revenue declines long term on shrinking demand for internal combustion engines, despite increasing penetration in ICE, exposure to globally popular sport utilities, and electrified powertrain growth potential.

“In our opinion, the market values BorgWarner as though fundamentals are in permanent decline, giving no credit for the company's economic moat in powertrain technologies and consistent ROIC generation above cost of capital.”

Daimler

The 4-star-rated shares of Daimler trade at a 43 per cent discount to Hilgert’s €85 fair value estimate.

“The market has overly discounted Daimler shares on uncertainty from US tariff policies, lower demand for diesel vehicles in Europe, and EU diesel equipment collusion charges.

“Despite our assumptions for significant margin pressure, our discounted cash flow model still generates an €85 fair value estimate that represents 63 per cent upside to the €52 consensus price target and 74 per cent upside potential versus the current market valuation.”

Delphi Technologies

5-star narrow-moat-rated parts supplier Delphi Technologies trades at a 74 per cent discount to Hilgert’s fair value estimate.

“Delphi Tech benefits from globally ubiquitous clean air legislation that requires passenger vehicle and commercial truck manufacturers to electrify powertrains and enhance efficiency of internal combustion engines.

“Fuel injector technology is currently Delphi’s largest product group. This represents a risk as manufacturers switch to smaller engines with fewer cylinders.

“Even so, the growth potential for Delphi’s electric and electronic powertrain products is substantial and represents margin expansion potential from software-based applications. We think Delphi revenue will grow at 1-3 percentage points above our long-term forecast for global light vehicle demand.

“We assume a 15.5 per cent normalised sustainable midcycle EBITDA margin, 160 basis points below 17.1 per cent historical 10-year high but 50 basis points above the 10-year median owing to more favourable product mix.”

Fiat Chrysler

No-moat-rated Fiat Chrysler trades at a 56 per cent discount to Hilgert’s fair value estimate.

“We assume 2 per cent average annual revenue growth and average adjusted EBIT margin of 6.2 per cent during our Stage I forecast. Our normalised sustainable adjusted EBIT margin assumption is 5.7 per cent.

“Management forecasts long-term average annualised revenue growth of 7 per cent and long-term EBIT margin to reach a range of 9 per cent to 11 per cent (five-year plan target to 2022) on the expansion of Jeep, Ram, Alfa Romeo, and Maserati brands.

“The company’s 2019 forecast includes EBIT of greater than €6.7 billion for a margin of greater than 6.1 per cent. 2019 revenue guidance was not specified, but the EBIT forecast implies at least flat year-over-year revenue.”

Tata Motors

Narrow-moat Tata Motors is India's largest commercial truck producer and owner of the Jaguar and Land Rover luxury, or JLR, brands. It is currently trading at a steep 72 per cent discount to Hilgert’s 465 Indian rupee/US$33 fair value estimate.

“We agree with the market’s concerns, including higher JLR debt levels, exposure to the Europe diesel market, the threat of a no-deal Brexit, degradation in JLR margin on industry-disruptive technology spending, and the downturn in China’s as well as India’s vehicle demand, but these issues do not change our long-term view of the firm’s normalised sustainable midcycle potential.

“Excluding joint venture equity income, Tata's 10-year historical high, low, and median EBIT margin is 10.2 per cent (fiscal 2011), 0.6 per cent (fiscal 2019), and 7.6 per cent.

“We have assumed a normalised sustainable midcycle EBIT margin of 7.5 per cent.”

Tenneco

The 5-star-rated shares of narrow-moat Tenneco stock trade at a compelling 82 per cent discount to Hilgert’s $73 fair value estimate.

Tenneco's emissions-control products meet strict air-quality legislation, optimise engine performance, improve fuel economy, and acoustically tune engine sound to fit a vehicle's profile. Ride-control products enhance safety by enabling improved steering, braking, and acceleration as well as improving ride comfort.

“In our opinion, Tenneco stock valuation has been unfairly punished because of the high level of debt after the Federal-Mogul acquisition; the postponement of the separation of DRiV, which implies previously unanticipated integration challenges; as well as transient operating environment and cost issues.

“The company has demonstrated an ability to perform in an unfavourable operating environment while carrying a high debt burden. In 2008 and 2009, total debt/EBITDA exceeded 4.0 times. In 2009, the stock hit a low of US70c. Since then, shares have traded as high as US$68.71 (2016), and total debt/EBITDA reached a low of 1.6 (2014). At the end of the second quarter of 2019, the credit metric was 3.5 times.

“Our forecast assumes 1 per cent pro forma average annual revenue growth from 2017 (the year before the Federal-Mogul acquisition) to 2023 versus a 4 per cent 10-year historical growth rate for old Tenneco. Our Stage I EBITDA margin assumptions average 9.7 per cent, with a normalised sustainable midcycle of 9.6 per cent.”

Volkswagen

Volkswagen stock trades in the 4-star range, with a 29 per cent discount to Hilgert’s €238 fair value estimate.

“Despite being in the valuation penalty box for the diesel emission scandal, spending for industry disruptive technologies, and the EC antitrust charges, we think the market valuation is compelling, especially with the €189 sell-side consensus price target at a 21 per cent discount to our fair value.

Volkswagen building

Volkswagen stock trades in the 4-star range, with a 29 per cent discount to Richard Hilgert’s €238 fair value estimate

“In our opinion, the market has been overly punitive in assessing technology spending and costs from the diesel emission scandal and the EC collusion charges. Even though the worst of the cheating scandal is over in the US, we maintain a €20 billion reduction to our enterprise value for potential litigation in Europe. If we remove the €20 billion EV haircut, our FVE would be €280.”

is content editor for Morningstar Australia

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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