Mercedes-Benz Group AG (OTCPK:DMLRY, OTCPK:DDAIF) fell like many stocks in the current bear market, where automakers have all been hit hard by fears of a recession and soaring inflation worries investors. However, I think the liquidation of the company opens up an interesting opportunity to start a position in the stock. Mercedes-Benz had already reshaped its business model and its main objective before the pandemic in order to become a more profitable company. It appears that the efforts undertaken are already paying off, positioning the company to weather any major market declines with a solid footing.
The change of strategy
Between 2019 and 2020, Mercedes-Benz announced that it wanted to evolve its business model from targeting volumes to moving its product portfolio to higher levels that ensure better profitability. Following this decision, the company carried out in 2021 the split of Daimler Trucks (DTRUY, DTGHF), which I recently spoke about in an article. In this way, Mercedes-Benz has moved away from a conglomerate structure to be clearly seen as a car manufacturer that aims to be one of the market leaders not in terms of cars sold, but in terms of profitability.
This objective was reaffirmed at the latest Capital Markets event, where Mercedes provided some interesting data.
As we can see, the company plans to decrease its entry-level luxury sales by -25%, reducing volumes from the 680k 2019 units to around 510k, while changing the average selling price (ASP) by 20 %, in order to reach a double-digit margin by 2026. For the basic luxury segment, sales volume should remain stable around 1.2 million units, with an increase in ASP of 25%. This segment already offers Mercedes higher margins. The high-end luxury tier already sells over 100,000 units and is expected to grow by 60%, with an ASP increase of around 15%. When we talk about high-end luxury, we are talking about cars that have an ASP over €100,000.
Now, Mercedes’ strategy will clearly lead to an initial drop in volumes, which will benefit margins and free cash flow. From 2019 to 2021, the company has already seen sales drop by around 400,000 units. Let’s take a closer look at Mercedes-Benz sales last year. Even though sales declined, we see that the bottom three segments declined, while the top three (S-Class, SUVs and Sports Cars) all saw their volumes increase.
In particular, the S-Class increased by 56%, SUVs by 6.6% and sports cars by 63.6%, as shown in the graph below.
Certainly, post-pandemic, many automakers saw their volumes decline due to supply chain constraints and semiconductor shortages. This has given all of them increased pricing power in the face of the huge increase in demand that we have seen. However, Mercedes-Benz had already started moving towards a business plan which was perfect for the situation we were facing, as it allows the company to channel demand and direct it to margin segments. higher.
In the Q1 2022 datasheet, Mercedes showed that it was not immune to the general decline in auto sales we are seeing, especially in Europe. However, it shows exceptional results for the S-Class, up 100%, and still positive results for the sports car segment. SUVs were indeed down, but not as much as the lower segments. In other words, I see a strategy that holds up well in a difficult environment and offers Mercedes Benz the opportunity to benefit from better profitability.
The choice of Mercedes comes from an understanding of the market that I will briefly recall. The company said it expects the global automotive market to grow at a CAGR of 1.2% this decade, while the premium segment will grow at a faster rate of 1.7%. and that the luxury segment, the real focus of Mercedes-Benz, will grow. at a CAGR of 4.2%.
The emphasis on the upper segments stems from a clear understanding of two main factors. First of all, a car is one of the most emotionally driven items purchased. This is all the more true when the car positions itself among the upper segments of the industry, thus being perceived not only as a vehicle, but as a luxury item.
The second factor that Mercedes is aware of is that between 2020 and 2025, a 50% increase in adults with a net worth of at least $1 million is expected. This will bring the Total Addressable Market (“TAM”) to 84 million individuals. This will make the luxury segment resilient as more individuals will have the wealth to purchase, perhaps for the first time, a luxury car.
Mercedes-Benz vs. BMW: different sources of margins
The Mercedes-Benz Group sold a total of 2.75 million vehicles in 2021, of which around 2 million were cars, while the rest were vans. Its industrial division revenue was €105.95 billion and an EBIT of €12.54 billion. This is a margin of 11.83%. Revenue from financial services (Mercedes-Benz Mobility) amounted to 27.7 billion euros with an EBIT of 1.44 billion euros or a margin of 5.2%. As we can see, Mercedes’ margins come more from car sales than financial services.
On the other hand, Mercedes-Benz’s main competitor, BMW (OTCPK: BMWYY), sold around 2.5 million cars in 2021, with a turnover of 95.48 billion euros and an EBIT of 9.87 billion euros. The margin here is 10.33%. Financial services revenue was €32.87 billion with an EBIT of €3.7 billion, with a margin of 11.26%. As I already pointed out in a recent article, BMW has focused on growing its financial arm in order to increase volumes and revenues. Moreover, it is from this branch that the company draws its margins, but, as I have pointed out, this strategy can be at risk because it is linked to the value of a used vehicle and to rates interest which can become too high, thus pushing customers to buy a car directly without being financed.
Mercedes-Benz sees its finances improving
So far we have seen two points: the change in strategy and the difference between Mercedes and BMW. Now we can see further how Mercedes’ strategy is actually executed with some interesting results.
While waiting for the results of 1H 2022, which Mercedes will publish in early August, we can take a look at 1Q 2022 to see that with generally declining volumes, EBIT is solid and growing, with RoS reaching 16.5 %, plus more than 1% above BMW. That was well above the expected return on car sales, which in its previous forecast Mercedes expected to be between 11.5% and 13%.
Let’s see where these results come from. As we can see from the slide below, Mercedes has increased its ASP by 40% in just two years. Meanwhile, it has also managed its fixed costs well, cutting them by 16%, as well as its investments, as production of electric vehicles begins to take off and therefore needs less money to expand. The result is an increasing RoS that went from 6.2% in 2019 to 16.4% in the first quarter of 2022. That’s really a big leap in a short time and I think that’s how Mercedes pulled off benefited from its change of strategy in a favorable environment.
Another result we can see from Mercedes’ change is that the company becomes free cash flow positive, as we can see from the chart below showing free cash flow per share. Please note that Mercedes does not engage in share buybacks, so the spike in free cash flow per share is entirely due to an actual increase in free cash flow.
Here is my discounted cash flow model. I’m a little conservative in expecting over the next five years a free cash flow (“FCF”) growth rate of just 4%, although I think we’ll see it benefit more from the new business strategy. by Mercedes. The result is that Mercedes is currently undervalued by around 30%, which in my case is starting to be a good enough margin of safety. Moreover, I think that even in the event of a recession, a more luxury-oriented company should hold up better than the others.
The stock also starts trading around $50, which has been both a support and resistance line for the past decade. For investors with a long-term mindset, this could be a good entry point to cautiously start a position that could be increased in case this bear market presents us with even better opportunities.