Is Daimler AG stock a Good Buy?

Over the last 5 years, the stock price of Daimler has fallen from a peak of 93 euros to 50 euros. That is almost a 50% decline. Is Daimler stock a good buy right now? Based on the latest closing price, a dividend payout of 3.25 euros per share translates to a dividend yield of approximately 6.5%. Is it a good deal? Let’s read on.

The first step before buying anything is to first understand the business. Hence, this article is written to provide a comprehensive overview of Daimler AG’s business. At the end of this read, you would definitely have a better understanding of Daimler and why its share price has fallen so much.

Let’s get rolling.

1. Daimler AG Business Overview

Daimler AG is in the automotive industry and they are a premium car manufacturer best known for its Mercedes-Benz cars. The business model of Daimler is in the development, production and distribution of vehicles across the world. Apart from cars, Daimler also sells trucks, vans, buses and provide financial services.

Below is a quick breakdown of each individual business units.

Source: Daimler’s Annual Report 2018

Daimler financial services support car sales in over 40 countries through tailored financing and leasing packages for customers. Approximately 50% of the total vehicles sold are being financed or leased by Daimler.

Apart from that, they also have innovative mobility solutions such as car2go (flexible car-sharing services), Moovel and Mytaxi.

On the latter point, Daimler AG has recently merged together with BMW group in 2018 to offer customers a single source for sustainable urban mobility services in the future.

Daimler AG and BMW Group will each hold a 50% stake in this joint venture. Mobility services refer to car-sharing, ride-hailing, parking, charging, autonomous vehicles and many more.

In essence, it is about reinventing how commuters travel across cities in the most convenient and sustainable manner.

2. Project Future Daimler AG

Source: https://www.daimler.com/company/project-future.html

Project future is Daimler’s bold restructuring move to reshape the organisation. It involves reassigning 700 subsidiaries in over 60 countries. Project Future is deemed the most comprehensive reorganisation in Daimler’s 130 years of corporate history and it is also one of the largest reorganisation undertook by a German company in recent years.

Previously, there were 5 business units in Daimler AG: Cars, Trucks, Vans, Buses and Financial Services. Under the new restructuring, Daimler wants to streamline down to just 3 independent legal entities: Mercedes-Benz AG, Daimler Truck AG and Daimler Mobility AG. All 3 divisions would fall under the umbrella group of Daimler AG.

Daimler AG would be in charge of strategy, governance and corporate functions. Cars and Vans would be combined together under Mercedes-Benz AG. Trucks and buses would be combined together under Daimler Truck AG. Mobility and financial services would be combined together under Daimler Mobility AG.

The motivation behind this new structure is to sharpen its focus, decentralise decision-making and encourage entrepreneurial innovations.

The new agile model also allows for more flexibility and Daimler can better position itself to take advantage of the rapid pace of change in the mobility sector. Raising capital and getting into new partnerships can happen more dynamically rather than going through the hierarchical corporate processes.

At the AGM on May 2019, the majority of the shareholders have approved this resolution and the new group structure is expected to take effect on 1 November 2019.

3. Financial Analysis

3.1 Revenue

Revenue for Daimler seems pretty strong over the past 10 years. 2018’s revenue came in at 167.4b euros. In 2018, Q1revenue was 39.8b, Q2 revenue was 40.8b and Q3 revenue was 40.2b. Quarterly revenue for 2019 is all higher than in 2018. It all looks good so far, but is that really the case? Let’s look deeper.

3.2 Earnings Before Interests & Taxes (EBIT)

EBIT is Earnings Before Interest & Taxes. It is a measure of a company’s operating profits. Broadly speaking, EBIT is derived by taking gross profit less off all other operating expenses/(income) before interests and taxes.

As you can see from the above chart, the figures don’t look as rosy anymore. There are some weaknesses showing up in 2018 and 2019. Despite increasing revenue as seen earlier, 2018 reported a drop in EBIT from the previous year. Even worse still, Q2 2019 made an EBIT loss of 1.56b euros.

The cumulative EBIT as of 2019 Q3 is 3.94 billion euros, a far cry from 2018’s 11.1 billion euros.

3.3 Net Profits

Daimler’s net profits follow a similar trend with EBIT. The net profit for 2018 is 7.25b euros. But you can see that the first half of 2019 has performed very poorly. Compared to the 2018’s net profits of 7.25b, cumulative net profit for 2019 is only about 2.72 billion euros.

4. Cash Flow Analysis

Let’s move over to the cash flow statement and see how Daimler is performing on a cash-basis. Cash is king and cash is the bloodline of a business. It is important to see what is going on here.

I would use Free Cash Flow (FCF) as a proxy to measure the cash flow strength of Daimler. Free cash flow is computed by taking operating cash flow less capital expenditures. A strong healthy company should see FCF growing over the years.

This is because it demonstrates that the business generated more earnings than the required capital expenditures to sustain and expand the business.

4.1 Free Cash Flow

The general trend of FCF is heading southwards. If free cash flow is negative, it simply means that the business does not make enough earnings to cover the necessary capital expenditures. More money is going out than coming in.

If the company’s earnings are insufficient, then how does it pay for the capital expenditures? Where do they find the money to make up for the gap? The answer is either through its own cash reserves or financing activities such as borrowings from creditors.

To measure the net inflow of cash borrowings that Daimler received, I took the total debt issued minus off total debt repaid.

4.2 Net Debt Issued

This shows the amount of new capital from borrowings. You can see that from 2014 to 2018, Daimler has been borrowing aggressively to finance its capital expenditures and business expansion.

However, debt works as a double-edged sword. It can either amplify returns or destroy shareholder’s value. Since we are on the topic of debt, it is worthwhile to analyse if there are any liquidity risks in Daimler.

5. Liquidity Analysis

5.1 Net Liquidity

Net liquidity is the current assets less current liabilities. It measures whether short-term debt obligations can be met with short-term assets such as cash and marketable securities.

From the above chart, it can be seen that the net liquidity has been falling over the quarters. Not looking good here. The net liquidity as of 2019 Q2 is 6.6 million euros. FY 2018’s net liquidity is 16.3 million euros. That is a more than 50% decline. Fortunately, 2019 Q3 showed improvements to 10 billion.

5.2 Capital Structure

Let’s look at the capital structure of Daimler. As of 2018 financial year-end, debt makes up 68.7% of total capital while equity makes up 30.7%. The remaining 0.6% goes to minority interests.

Another way of looking at it is for every dollar of an asset purchased, 69% of it is being funded by debt while 31% of it is being funded by equity.

5.3 Debt-to-Equity Ratio

Knowing the capital structure can also give us the debt-to-equity ratio. The debt-to-equity ratio for Daimler AG is 219%. This means that the company is borrowing 2.19x more than what it owns. For every $1 in equity, it borrows $2.19 in debt.

Generally speaking, the higher the D/E ratio, the riskier the company is. This is because it is using more debt and financial leverage to operate the business. However, capital-intensive industries like telco and automotive tend to have a higher D/E ratio.

Based on Damodaran’s data in 2019, the average D/E ratio in the automotive industry is 195.44%. This means that Daimler is taking on even higher debt leverage in comparison to the benchmark average.

The merit of using debt is that it is cheaper than the cost of equity. Interest expenses are also tax-deductible while equity isn’t. This would help generate tax savings for the company as a whole.

As long as the company is able to generate returns higher than the cost of borrowings, using debt can help a firm to expand faster and maximise profits.

The risk of using debt is that it incurs a debt obligation to creditors. Daimler has to pay higher interest expenses resulting in higher cash outflows. One way we can measure the risk of debt is to look at the interest coverage ratio. Interest coverage is calculated by taking EBIT / interest expense.

5.4 Interest Coverage Ratio

Interest coverage measures the number of times a firm can pay off its expenses from its operating earnings. The higher the figure the better and the lower the riskier. Let’s see how Daimler fare.

Daimler’s interest coverage has been declining since 2015. If you will notice, the time it starts declining coincides with the same period when Daimler starts shoring up its debt aggressively. Net debt issued has risen from 4.8b in 2014 to 17.5b in 2018. (Refer to diagram 4.2)

At the same time, EBIT is also not strong enough to tank the increase in debt obligations. This is especially so in 2018 and 2019 where the company recorded a loss in the 2nd quarter. This is the reason why you see the interest coverage ratio falling.

The next question you might ask is why EBIT is not strong enough? If the company borrows more, invests more, shouldn’t earnings be higher? This brings me to the next point which is measuring the profitability or efficiency of capital management.

6. Profitability

If they are borrowing so aggressively, why are earnings not catching up? let’s look at the profitability metrics.

When measuring profitability, I plotted Return on Assets (ROA), Return on Invested Capital (ROIC) and Return on Equity (ROE) on the same chart.

While it all looks similar, there are some nuanced differences to be pointed out. ROA and ROIC both use the same numerator. It is EBIT x (1 – tax rate) as we want to find out the net operating profits after tax. It represents earnings the company made before paying out interest expenses to all the debtors.

On the other hand, ROE uses net income excluding unusual items. This is because the profits that belong to equity holders comes only after all debt obligations are paid to the creditors.

The denominator for ROA is the average total assets between the current year and prior year. ROIC is total capital (shareholder’s equity + total debt) and ROE is the average of total equity between the current year and prior year.

ROA measures the efficiency of assets. ROIC and ROE measure the return on capital, except that the former includes debt while the latter excludes.

I like to use Return on Invested Capital (ROIC) as a proxy for capital efficiency. For a detailed read up on why ROIC is a better measure than ROE or ROA, please refer to the earlier post here.

Nevertheless, regardless of which metric you used, all of them are declining. The average returns for ROA, ROIC and ROE is 3.2%, 4.5% and 16.1% respectively. So you can do a quick comparison of how the LTM’s figures performed.

ROIC of 1.8% is extremely low. If Daimler’s effective cost of capital is higher than 1.8%, the firm is technically making a loss for every dollar of capital invested.

7. Operational Analysis

Alright, that is enough of financial analysis for now. Let’s move over to the operational figures.

7.1 Revenue by Geographic Segments

7.2 Revenue by Business Units

From the above two pie charts, you can see that Mercedes-Benz cars are their core product as it makes up more than half of the group’s total revenue. Daimler Trucks came in second as it accounts for a quarter of total revenue. The rest are vans, buses and financial services.

7.3 Total Units Sold by Categories

I dug up past annual reports to collate the total units sold based on each category. Total units sold for 2018 came in at 3.35 million. Mercedes-Benz cars show the highest growth in units sold while buses remained stagnant.

7.4 Return on Sales based by Categories

If you think about it, why units sold for buses remain so low? Why did Daimler not increase the production of buses? And why did they focus mostly on Mercedes-Benz cars? The reason is because of the return on sales.

Return on Sales is calculated by taking operating profits within each category divided by their revenue. This would give us insights into the efficiency of production and operational costs. Mercedes-Benz cars and trucks give the highest margin while buses and vans are lower.

Theoretically speaking, every business has capacity and cost constraints due to a limited amount of resources. Given the return on sales figures, how would you best allocate your resources to maximise revenue and profits?

That is the reason why you see Mercedes-Benz cars sold the most, followed by trucks. After all, that is what Daimler is known for. Furthermore, as factories expand and production units increase, economies of scale would lower the cost of production thus increasing return on sale margins.

7.5 Top 10 Markets by Business Units

China is the top market for Mercedes-Benz cars, US for trucks, Germany for Vans and Brazil for buses. Knowing this information is useful as it directs our attention to the markets that drive Daimler’s earnings.

If you know cars are Daimler’s core product and most of its sales come from China, would this news concern Daimler? Probably yes.

Image result for china car sales 2019 slump 15 out of 16
source: https://www.bloomberg.com/news/articles/2019-10-12/historic-slump-in-china-car-market-continues-as-sales-drop-6-6

If you want to look for signs of weakness or strength in earnings, the key operational data is to look at Daimler’s car sales in China and Daimler’s truck sales in the US.

8. Dividend Yield

Source: S&P Capital IQ

Daimler’s dividend yield is approximately 6.7% right now. We are near the upper bound region as the historical average yield is 4.27%. This is based on a 20-year time frame.

The dividend payout ratio ranges from 38% to 48% over the past 5 years. Is it sustainable? While it might look reasonable to payout 48% of net profits to shareholders, we have discounted the fact that net earnings are not cash.

8.1 Owner Earnings

Since dividends represent cash outflow, we should look at cash inflow to better understand where the money is going. Hence, a more appropriate measure would be free cash flow or what Warren Buffet terms it “Owner earnings”. You can read more about it under the 12 immutable tenents of a business.

If we were to really take owner earnings as a measure, Daimler would already be in the negative.

Source: S&P Capital IQ

Take a look at cash flow from operations and CAPEX. It has already spent most of its cash buying inventories. This is because the line item “Change in Inventories” is negative.

Apart from that, the driving force for why operation cash flow is because account receivables from Daimler financial services have increased. Since revenue does not equate to cash received, we have to less off the difference from net profits.

However, some might argue that Daimler financial services do not represent the operating business of their automotive vehicles. While I use the group’s consolidated free cash flow, Daimler used free cash flow from the industrial business, which excludes the financial services division.

source: https://annualreport.daimler.com/ar2018/combined-management-report/liquidity-and-capital-resources/cash-flows

Even if we take the free cash flow of the industrial business, which is what Daimler used in their management report, it is still $1 billion euros lower than the amount of dividends paid.

In essence, they are paying more than they earned. This excess either comes from the debt they borrowed or the cash they have in their balance sheet. Either way, it is not a healthy sign. In my opinion, this is simply not sustainable and unless earnings start improving, it would not be long before they issue another round of dividend cut.

9. Daimler’s Profit Warnings

The question that is lingering in your mind right now is probably asking what happened in 2018 and 2019. Why did EBIT take a turn and why is there a negative EBIT in the second quarter? Here are the following reasons:

  • Weaker-than-expected growth in global car markets
  • Slower car growth in China
  • Structural shift in automotive (car-sharing reduce the need for ownership)
  • Expenses in connection with ongoing governmental proceedings and measures relating to diesel vehicles
  • Mercedes-Benz Vans posted lower unit sales due to delivery delays
  • Lower SUV sales and higher costs due to higher tariffs on imports from the US to China
  • Higher expenditures for new technologies and vehicles (autonomous driving and electric vehicles)
  • One-off effects totalling 4.2 billion euros on emission cheating and vehicle recalls (the reason for 2019 Q2 negative EBIT)
  • Mass recall over faulty Takata airbags, expected provision expenses around 1 billion euros
  • Diesel-related provisions alone are expected to reach around 1.6 billion euros

Daimler is facing a lot of headwinds in the coming years ahead. The vehicle recalls and regulatory fines have dragged down their bottom line substantially. We are talking about billions here.

Not only that, “Project Future” – Daimler’s ambitious restructuring plan is expected to cost around $700 million euros with a 15% reserve. Running costs after the restructuring is expected to be about $155 million with a 10% reserve. These are estimates made from Daimler AGM 2019.

The expenses from restructuring will further put a strain on Daimler’s operating profits. In such a situation, there will always be a transitional phase to regroup and refocus before going on the offensive. In other words, it is likely that they would focus more on internal cost savings before increasing external sales revenue.

10. Conclusion

The management has adjusted its earnings guidance for 2019. The outlook for EBIT is expected to be significantly lower than the previous year. The free cash flow of the industrial business can no longer be higher than in 2018.

ROS for cars is expected to drop to 3-5% from 6-8%. Trucks, buses and financial services remained unchanged. ROS for vans is expected to drop to -15% to -17% from -2% to -4%.

Profits are dropping due to recalls and weaker macroeconomic conditions. Cost pressure is also rising due to higher expenditures on technology developments and restructuring. Uncertainty on provisional expenses lurks. Net liquidity is falling and the cash flow situation is not looking good. Debt is high and it poses a risk especially in a cyclical business like automotive.

It is going to be tough for Daimler’s new CEO, Ola K√§llenius. His immediate priority in 2019 is to focus on cost-cutting as he aims to eliminate inefficiencies and cut down central administrative costs by 20%.

If we take 2018’s G&A expenses of $3 billion euros, 20% would be about $600 million euros. If this amount can offset the restructuring costs of $700 million, and sales start showing signs of improvements, there is a chance that Daimler might turn.

However, as with all other things in life, there is a cycle. If the global economy is contracting and growth is slowing, all businesses would suffer temporary losses. But if Källenius can defy all odds, tide through both internal and external challenges, and bring Daimler to greater heights, he would certainly win the respect and admiration from all stakeholders within the automotive industry.

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