German automakers and the China yuan shock

Yuan may depreciate to 6.8 against the US dollar by early 2016 and hit Chinese consumer demand for luxury German automobiless, writes Matein Khalid

I had mused about the catastrophic impact of Chinese financial turmoil on Daimler shares in a column I published last Monday. I had calculated that the shares had 10-12 per cent downside risk to ?74. So imagine my shock when the People's Bank of China devalued the yuan and Daimler fell 10 per cent in two sessions to ?76. As anyone who has visited Shanghai or Beijing knows, Mercedes Benz SUVs are a status symbol in the Middle Kingdom. Daimler is exposed to China macro risk as the yuan could well depreciate to 6.8 against the US dollar by early 2016 and hit Chinese consumer demand for luxury German automobiles. However, the investment case for Daimler rests on its fabulous cash flow generation, strong US truck (Freightliner) market, the five per cent dividend. At ?76, Daimler now trades at below eight times forward earnings and 3.4 times enterprise value/Ebitda, 1.3 times forward price/book value metrics that I feel incorporate "China risk" in the shares.
While Daimler produces 190,000 Mercedez Benz units in China, Volkswagen produces more than 3.34 million units and BMW exposure on imported/locally manufactured sedans and coupes is 450,000 units. This does not mean Daimler will be unscathed from the yuan shock. Last week's share price plunge was entirely rational and justified. With Daimler shares now 25 per cent below recent highs, my valuation paradigm tries to guesstimate a credible trading range where the risk/reward is skewed in my favour. I believe Daimler could well trade in a ?65-?85 range as China angst will continue to pressure the shares.
I did not explain my bearishness on BMW last week. I was disappointed by BMW's earning risk and the Street grapevine suggests management will be forced to lower 2015 earnings guidance. There is no doubt that BMW sales growth is decelerating and not just in China. BMW's China imports business is in structural decline and this will have a baleful impact on operating profits, EPS growth and margins. The valuations or dividend yield/free cash flow generation potential is nowhere near as attractive as at Daimler. Unlike Mercedes Benz, then no new product launch cycle to goose the shares until 2017. There is no credible case for a valuation rerating on BMW. This was my thinking behind the idea of a potential trade "long Daimler/short BMW", a sunrise-sunset spread.
It is impossible for me to justify an investment case for Porsche, as its governance model is not transparent, its share are a proxy for its Volkswagen stake, its holding company structure argues for a valuation discount and German court rulings are, by their very nature, unquantifiable.
Volkswagen has also de facto reduced unit sales volume guidance. The China joint ventures profit contribution just got slammed by the yuan shock. In any case, the China joint venture profits were down 17 per cent even before the yuan devaluation. This means there is significant EPS disappointment risk in Volkswagen shares. The "cheap" valuation metrics are actually a value trap for investors. The significant "China risk" alone makes a valuation rerating impossible. Volkswagen shares have underperformed in Frankfurt and I see no reason for this scenario to change. I will not be surprised to see Volkswagen shares trade down to ?150. After all, Volkswagen is the largest auto brand in China, with GM, Nissan, Hyundai and Toyota also vulnerable.
There is no doubt that China is a source of fundamental, even existential risk to global autos/component suppliers. This is the reason for my unwillingness to buy Ford and General Motors at their (superficially) attractive valuations. Note that General Motors shares have fallen 12 per cent in 2015 and trade at 52-week lows below 30. Ain't no sunshine when she's gone - to testify before Congress!
The China yuan shock is a disaster for Thailand, Asia's auto hub, whose capital Bangkok is the Asian Detroit. Asian markets has hugely dependent on Chinese exports, as the woes of the Korean won, Taiwan dollar, Singapore dollar, Indonesian rupiah, Thai bhat and the Malaysian ringgit (4.0 now, down 19 per cent against the dollar despite Bank Negara intervention). Hyundai Motors sales in China fell eight per cent in 2014-15 even before the yuan shock. Note that Nisan is also hostage to China risk since its strategic partner Dongfeng Motors also reported falling sales. It is a testament to China's grim auto sector realities that Nissan sales fell 14 per cent in the PRC despite the Abenomics linked epic devaluation of the Japanese yen.