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Investment Thesis
In October, Daimler AG (OTCPK:DDAIF) revealed its new strategic course to pursue profitable growth in the luxury car segment, while targeting industry leadership in electric drive and car software development. Since then, the German car manufacturer lost no time to execute on its promise by restructuring the company, achieving a milestone in autonomous driving, and readdressing key markets of battery electric vehicles (BEV). As a result, Daimler’s long-term outlook is positive due to opportunities in the high-end car segment and structural changes in the automotive sector towards electronic mobility only. Investors can find value in attractively priced Daimler, while collecting an appealing dividend along the way.
Executing Against the New Strategy
Daimler Truck Spin-off
Most of today’s passenger cars, trucks and buses have one common similarity, they are likely being powered by an internal combustion engine (ICE). Besides their shared engine technology, there is little to no synergies for manufacturers when it comes to developing, marketing or selling their models to potential buyers. Daimler’s management also reached this conclusion, proposing a significant change for the company. In order to focus on its high-end car segment including key brand Mercedes Benz, Daimler decided to separate the truck and bus division of the company via spin-off into a publicly listed company named Daimler Truck Holding AG (OTC:DTRUY). Daimler shareholders received one Daimler Truck Holding share for every two Daimler shares held. Next, Daimler AG will rename itself to “Mercedes-Benz Group AG” in February, while continuing to hold a 35 percent share of Daimler Truck Holding AG going forward. The truck and bus division had little overlap with the passenger car business when it came to development, marketing, and sales channels. The separation of the two business segments, allows Mercedes-Benz to focus on its higher-margin passenger vehicles and light commercial vans segments; as well as Daimler Mobility, which includes financial services and other mobility services like ridesharing.
First Manufacturer to Achieve Level 3 in Autonomous Driving
If you’d ask someone about self-driving cars, I expect that most people associate either Google (GOOGL) or Tesla (TSLA) with the future of autonomous vehicles. Especially Tesla’s autopilot is widely known and gets regular coverage, both positive and negative, in media outlets. However, Mercedes-Benz is the first automotive company in the world to achieve international system approval of a SEA Level 3 system. The German Federal Motor Transport Authority granted the approval to Mercedes-Benz in early December. The company will be able to deliver its S-Class model with DRIVE PILOT, its autonomous driving system, in the first half of 2022. According to Mercedes-Benz, “DRIVE PILOT enables customers to drive in conditionally automated mode at speeds of up to 60 km/h in heavy traffic or congested situations on suitable stretches of motorway in Germany, allowing them to take their mind off the traffic and focus on secondary activities.” Being the first car manufacturer to be granted a Level 3 approval in autonomous driving shows Mercedes-Benz’s commitment and potential when it comes to self-driving cars. The Level 3 certification is just the first step of Mercedes-Benz to challenge other manufacturers and software companies for leadership in the automotive sector and self-driving cars.
China and Europe Will See Massive BEV Growth
In the past decade, electric powered vehicles used to be a rarity on public roads and finding a loading station to charge them was even more scarce. However, sales volumes of BEV have accelerated significantly over the past years and will continue to do so in the next years. In 2020, battery electric vehicles sales in China and Europe represented about 80 percent of the global BEV market. Estimates project that BEV sales will reach about nine million in China and close to six million in Europe by 2030. Key drivers of this growth include state subsidies, ESG trends amongst corporations and consumers, as well as technological improvements in driving-range, affordability of BEVs, and broadly available charging capabilities.
According to Daimler’s recent Q3 earnings report, China represents Mercedes-Benz’s largest market while the European Union is its second largest. Thus, Mercedes-Benz’s focus on electric-only is positioning the company in both markets to benefit from the future growth of BEV sales in China and Europe.
Shifting Investments from EV-first to EV-only
As demand for BEVs will grow in Mercedes-Benz’s largest markets, the company is currently not well positioned with its existing product portfolio that offers limited options of electric powered vehicles. In effort to make up for lost ground against competitors like Tesla, Volkswagen (OTCPK:VWAGY) or Stellantis (STLA) who are leading the BEV market in Europe and globally, Mercedes-Benz is shifting its research and development efforts from electric-first to electric-only product portfolio.
Consequently, all newly launched vehicle architectures will be electric-only, and Mercedes-Benz customers will be able to purchase an all-electric version for every model the company makes by 2025. This exclusive focus on electric-vehicle development will not only result in faster advancements in BEV technology and its supportive ecosystem, but also lower corporate spending and more effective capital allocation. This shift of resources away from developing new internal combustion engines (ICE) is reasonable as the total addressable market for ICEs will decline, while the TAM for BEVs will continue to grow. Daimler will therefore use its capital more effectively rather than pursuing a joint-development roadmap that includes ICE and BEV investments.
Daimler reducing its stake in unsuccessful China joint venture Denza
While tailing its competitors in the European BEV market, Daimler entered the market for “vehicles with alternative drives” in China a decade ago. Together with BYD Company Limited (OTCPK:BYDDF), Daimler launched a joint venture under the Denza brand. However, the company has seen very little success in the highly fragmented and competitive Chinese automobile market. Since the first model was launched in 2014, Denza has sold only 23,000 vehicles. Among the more than one hundred car brands that sell in China, Denza is ranked 80th – with a market share of only 0.02 percent. Consequently, Daimler recently announced that it will withdraw itself from its China failure by lowering its stake to ten percent. The other 90 percent will be held by BYD in the future. The completion of the transaction is planned for mid-2022. This exit from its failed China experiment was long overdue, and I applaud management’s decision to refocus its resources on a better go-to-market approach.
Rather than building a new brand or pursuing the unsuccessful Danza joint venture further, Daimler will leverage its existing core brands and partner network to capture market share in the Chinese automotive market. In order to grow Daimler’s Smart brand, the German automaker has formed a joint venture with Geely Automobile Holdings Limited (OTCPK:GELYF) to develop new BEVs for the microcar market. Production will be based in China, with sales planned to start in 2022.
For its luxury brand Mercedes-Benz, the German car manufacturer will continue to leverage its existing and longstanding partner BAIC Motor Corporation Limited (OTC:BCCMY) to also localize and produce its Mercedes-Benz EQA, EQB and EQC models regionally in China. Focusing on Geely and BAIC as local partners in China will allow Mercedes-Benz to capture additional market share in the largest automotive market worldwide.
Valuation and Dividend
When Mercedes-Benz reports full year earnings on February 24th, we’ll get our first look at how the company looks after the separation from its truck and bus division. Due to the spin-off, the total revenue base, EPS and cash flow of Daimler will come down. At the same time, profitability will reset to new levels, as the Mercedes-Benz Cars & Vans division shows adjusted return on sales of 10%-12%, while Daimler Trucks & Buses division has adjusted return on sales of 6%-8%.
Shares of Daimler currently trade for €74.79. The average twelve-month price target of 24 analysts covering the company is €90.94, implying a 21% upside to current trading levels. 13 analysts have a buy rating on the stock. Analysts estimate Daimler’s 2021 EPS to be €11.39, resulting in a forward P/E ratio of 6.5, which is well below Daimler’s historic average of 9.7 and compares to an automobile manufacturer median of 16. If Daimler’s P/E ratio returns to its historic average, then the stock could be trading at €110.48 per share. If Mercedes-Benz executes well on its strategy, resulting in sales and margin growth then a P/E ratio closer to the industry average is possible, offering additional upside for long-term investors.
While investors are closely following management’s steps to deliver on the strategic objectives, they can collect a reliable dividend that is above the industry average. Based on last year’s payout of €1.35, the stock is currently yielding around 1.8%. However, shareholders can expect a dividend raise driven by higher earnings, since management targets a payout ratio of 40%. As stated above, analysts expect EPS for 2021 to be around €11.39 (low: €10.34, high: €12.34). If we apply a payout ratio of 40%, then investors can expect a dividend of €4.55. Based on the current stock price of €74.79 this equates to a yield of 6%. Even at the low end of analyst estimates (€10.34) the stock would still yield 5.5% based on a 40% payout ratio.
Risks to Consider Before Investing in Daimler AG
The following risks should be considered before buying Daimler AG stock:
- Disruption of global supply chains for electronic components and microchips which are essential for production, causing production shortages and factory shutdowns.
- High level of inflation; especially the rise in energy prices, steel, and other critical components of the manufacturing process. Heightened inflation could also affect private households’ consumption and companies’ investment activities, thus reducing demand for cars and commercial vehicles.
- Legal proceedings and potential penalties in connection with numerous governmental authorities and institutions worldwide investigating activities particularly related to test results of emission control systems used in Mercedes-Benz diesel vehicles.
- Economic risks in China due to the current developments in the real-estate sector and a potential subsequent financial crisis, resulting in negative consequences for economic growth and Chinese demand for cars and commercial vehicles.
Conclusion
As a current Daimler shareholder, I am pleased about the latest strategic moves management undertook. Its recent Daimler Truck spin-off and focus on luxury car segment are expected to improve Daimler’s operating margins and return on capital. Considering that autonomous-driving technology is in the early stages of development and adoption of BEV is still low, there are significant growth opportunities available for Daimler in its core markets. Reflecting on its current valuation, Daimler is an interesting choice for investors that are looking for exposure to electric vehicle and autonomous driving trends. Thus, I am happy to hold on to my Daimler shares and see the company execute on its growth strategy, while collecting an attractive dividend yield along the way.
Thank you for taking the time to read my article. If you have any further thoughts or feedback, I am happy to hear from you.