Third Avenue Management Letters - BMW Investment

Third Avenue Management – Matthew Fine on Bayerische Motoren Werke AG (ETR: BMW)

BMW and the luxury auto industry

We’re trying a new format for posts today. Traditionally, we’ve liked to study the frameworks, thinking methods and mental models from books and letters. But it’s also helpful to learn from case studies and the way experts think about individual companies, industries or geographies. In Beating the Street, Peter Lynch described the merits of a 90-second narrative to understand an investment or business decision. That’s the idea here, but in a learning sense.

In this post, we’ll look at Third Avenue Management’s value-oriented investment in Bayerische Motoren Werke AG (ETR: BMW). This isn’t an endorsement of the fund, company or stock. Instead, we’re interested in how Matthew Fine (their portfolio manager) has thought about the economics of BMW and the auto industry. It’s an exercise in learning.

“Our strategy seeks long term capital appreciation by investing opportunistically… to build a differentiated portfolio of contrarian and special-situation opportunities. The fund’s investments are generally characterized by what we believe are strong financial positions, valuation supported by tangible assets and market prices substantially below our estimate of intrinsic business value.”
Third Avenue Management, Value Fund Strategy

Narrative headwinds

Financial markets haven’t viewed BMW too favourably over the last few years (at least prior to early 2020). Third Avenue attributes this to a combination of headwinds that the German automaker and industry faces. Of course, electrification, autonomous driving and ride-sharing technologies are big disruptions on the horizon. We’ve also seen the meteoric rise of new competitors. Tesla and Elon Musk in particular have attracted much of the automotive attention of late. Meanwhile, diesel emission scandals, environmental regulations, geopolitical tradewars and slowing global growth have brought more reputation, demand and supply-side challenges to industry. These factors have made the narrative for traditional automakers more uncertain and less compelling.

However, Third Avenue felt that the market price of BMW stock had reflected a great deal of pessimism between 2018 and early 2020. BMW, in their opinion, was better placed than other automakers to navigate these industry challenges.

XETR : BMW stock chart

Luxury v mass market

Firstly, as described in their 2018 letter, the luxury auto-manufacturing market is more attractive than the mass-market. Historically, the segment has enjoyed higher operating margins, lower cyclicality and fewer competitors. The segment remains an oligopoly in which Daimler (Mercedes), Volkswagen (Audi) and BMW dominates. Third Avenue describes how these factors have helped BMW to earn a relatively strong return on capital and balance sheet (A2 on Moody’s and amongst the highest in industry). This is a competitive advantage when it comes to reinvestment in manufacturing, engineering and electrification for the long-term.

Slowing growth

Another prevailing narrative of concern was slowing growth, particularly in China and the United States. Third Avenue agrees that it’s difficult to know which phase of the automotive cycle that we’re currently in. Keep in mind though that BMW Group deliveries to China have almost tripled from 234K units in 2011 to 724K units in 2019. And deliveries to the United States have remained relatively stable, between 300K-400K annually over the last decade. In Third Avenue’s opinion, the market had already priced BMW for an “expected cyclical downturn” and “reflect[ed] an enormous amount of pessimism”. BMW shares for instance were trading at a 25% discount to book value in 2019 (more on valuation later).

Electric revolution

Third Avenue is also somewhat doubtful of the “rule of thumb” that around 30% of passenger vehicle sales by 2030 will comprise of electric vehicles. As they wrote in their 2019 letter, “while EVs have garnered enormous attention, today they represent approximately 2% of the global passenger vehicles sold”. Many geographies for example have a long way to go to build their charging infrastructure. Resource constraints may create further challenges to production too. Third Avenue for example outlines how growth in demand for electric vehicles, charging stations and electric grid enhancements will translate to increased global demand for copper. Since it can take as long as a decade to develop new copper mines, rapid adoption might lead to copper shortages and cost inflation. They’re less optimistic than others when it comes to the pace of adoption.

New competitors

Regardless, Third Avenue believes that BMW is well positioned to succeed in the electric vehicle revolution. Relative to their newer competitors, BMW benefits from its stronger profitability, healthier balance sheet, well-established distribution and service networks, “engineering prowess, manufacturing efficiency, and lots and lots of money to fund research and development”. Even their financial services enjoys a unique advantage over newer and mass market players when you stop to consider the credit rating of your typical BMW customer. Third Avenue says these competitive advantages are necessary to navigate not only the near-term challenges of industry, but for multiple model refresh cycles to come. And as it stands, BMW remains one of the more successful producers of electric vehicles today.

Valuing BMW

“In common stock investing, … [the] focus is on buying into well-financed companies at steep discounts from readily ascertainable NAV where there are reasonable prospects for double digit NAV growth over the next five years or so… with a low probability of permanent capital loss over our long-term investment horizon.”
Martin J. Whitman, Founder, Third Avenue Management

Finally, Third Avenue outlines four sources of value for BMW: (1) automaking operations; (2) financial services (auto purchase and lease financing); (3) joint venture with Brilliance Auto in China; and (4) strong net cash position.

The market in their view had undervalued BMW for much of 2018, 2019 and early 2020. At the time of writing in 2018, Third Avenue reported that BMW shares were trading at ~7x earnings, ~1x tangible book value and nearly a 10% free cash flow yield. Note also that BMW held around EUR 20 billion in net cash (excluding its financial services segment). In March 2020, they reported that BMW’s market cap was less than “the net cash and financial assets in its automotive business (EUR 17 billion) plus the book value of its financial services business (EUR 15 billion)”. And as they wrote in the 2019 letter:

“At the current share price, if we subtract the net cash balance as well as the value of the joint venture and the finance business… we are left with roughly EUR 9.6 billion of market value attributable to one of the world’s preeminent auto manufacturing businesses, which, mind you, produced pre-tax operating income of EUR 4.7 billion over the last twelve months.”
Third Avenue Management, Q2 2019 Letter

Final thoughts

Overall, Third Avenue’s stake in BMW reflects their disagreement with the prevailing sentiment towards traditional automakers. BMW’s luxury status, balance sheet and market price afforded a margin of safety that they felt attractive. This post, of course, is a gross oversimplification of the details pertaining to BMW, automotive manufacturing and electric vehicles. But it may offer you a starting point to form your own due diligence and conclusions.

Source: Third Avenue Managment. 2018-2020 Value Fund Shareholder Letters. Available at <https://thirdave.com/shareholder-letters/>