Valuation of BMW PDF

Bachelor Thesis Department of Business Studies Århus, the 3rd of May 2010 Valuation of BMW - Financial & Strategic Analysis Authors Rasmus Ramshøj Pløen...

Bachelor Thesis Department of Business Studies Århus, the 3rd of May 2010 Valuation of BMW - Financial & Strategic Analysis Authors Rasmus Ramshøj Pløen Mikkel Kronborg Olesen Exam no. 282821 Exam no. 283755 BSc (B/IM) BSc (B) Academic Advisor Nicolai Borcher Hansen ASB Aarhus School of Business  TABLE OF CONTENTS 1 PREFACE................................................................................................................................................................ 4 1.1 EXECUTIVE SUMMARY................................................................................................................................................ 5 1.2 BRIEF INTRODUCTION................................................................................................................................................. 6 1.3 PROBLEM STATEMENT................................................................................................................................................ 8 1.4 STRUCTURE.............................................................................................................................................................. 9 1.5 DELIMITATIONS AND ASSUMPTIONS............................................................................................................................ 10 1.6 METHODS.............................................................................................................................................................. 12 2 HISTORICAL FINANCIAL ANALYSIS........................................................................................................... 13 2.1 REARRANGING THE BALANCE SHEET - ANALYZING INVESTED CAPITAL.................................................................................. 13 2.2 REARRANGING THE INCOME STATEMENT – ANALYZING NOPLAT...................................................................................... 14 2.3 ANALYZING THE FREE CASH FLOW.............................................................................................................................. 15 2.4 REINVESTMENT RATIOS............................................................................................................................................. 16 2.5 RETURN ON INVESTED CAPITAL (ROIC)........................................................................................................................ 16 2.6 ANALYSIS OF REVENUE GROWTH................................................................................................................................. 17 2.7 CAPITAL STRUCTURE – OPTIMAL CAPITAL STRUCTURE.................................................................................................... 18 2.8 PEER GROUP FINANCIAL RATIOS.................................................................................................................................. 20 2.9 CONCLUSION ON THE FINANCIAL ANALYSIS................................................................................................................... 21 3 THE COST OF CAPITAL................................................................................................................................... 21 3.1 ESTIMATING MARKET VALUE WEIGHTS & TAX.............................................................................................................. 21 3.2 ESTIMATING THE COST OF EQUITY.............................................................................................................................. 23 3.3 THE CAPM EQUATION............................................................................................................................................. 24 3.4 ESTIMATING THE COST OF DEBT................................................................................................................................. 28 3.5 CONCLUSION.......................................................................................................................................................... 29 4 EXTERNAL STRATEGIC ANALYSIS............................................................................................................. 31 4.1 THE DEGREE OF TURBULENCE.................................................................................................................................... 31 4.2 PEST.................................................................................................................................................................... 32 4.3 PORTER ‘S 5 FORCES................................................................................................................................................ 37 5 INTERNAL STRATEGIC ANALYSIS.............................................................................................................. 43 5.1 TANGIBLE ASSETS.................................................................................................................................................... 44 5.2 INTANGIBLE ASSETS.................................................................................................................................................. 44 5.3 ORGANIZATIONAL CAPABILITIES.................................................................................................................................. 45 5.4 MC KINSEY’S 7S MODEL........................................................................................................................................... 46 5.5 EVALUATION OF INTERNAL RESOURCES......................................................................................................................... 49 6 KEY FACTORS OF SUCCESS (KFS)............................................................................................................... 51 7 SWOT ANALYSIS............................................................................................................................................... 52 7.1 PRIORITIZING BMW’S STRATEGIC CHALLENGES............................................................................................................. 52 7.2 CONCLUSION ON THE STRATEGIC ANALYSIS................................................................................................................... 55 8 FORECASTING AND VALUATION................................................................................................................. 57 8.1 FORECAST DRIVERS.................................................................................................................................................. 57 8.2 SHORT TERM FORECAST FOR THE INCOME STATEMENT.................................................................................................... 58 8.3 SHORT-TERM FORECAST FOR THE BALANCE SHEET.......................................................................................................... 61 8.4 LONG TERM AND CONTINUING VALUE FORECAST DRIVERS................................................................................................ 62 8.5 VALUATION............................................................................................................................................................ 63 8.6 DIFFERENT STOCK CLASSES......................................................................................................................................... 64 8.7 SENSITIVITY ANALYSIS............................................................................................................................................... 66 8.8 PRELIMINARY CONCLUSION........................................................................................................................................ 69 Page 2 of 93 9 CONCLUSION...................................................................................................................................................... 70 10 BIBLIOGRAPHY................................................................................................................................................. 72 11 APPENDICES....................................................................................................................................................... 76 Page 3 of 93 1 Preface This report was written for an academic audience, where pre knowledge about basic economic terms is assumed. Still economic terms will be written out, when the reader is introduced to them for the first time. In order to ease up the access to this report, the structure has been visualized in appendix one in the back of the report. Along the report comes a CD with a copy of the report and all the relevant spreadsheets, which have been used for the valuation. The spreadsheets have been created from scratch instead of using a standardized spreadsheet, which can be bought from e.g. McKinsey. This has been done in order to get comprehensive understanding of the company’s accounts and the reorganization of financial statements. Reading the report without having to look forth and back has been a major concern for the writers, which made it a necessity to include a PowerPoint Slide Show consisting of the appendixes, which can be used while reading. It is therefore recommended to keep the slideshow open on the computer while reading. The length of the report is within the limits given by the Aarhus School of Business for a Bachelor project for two persons (Appendix 14). Page 4 of 93 1.1 Executive summary This report takes its starting point in the evaluation of the BMW Group through historical financial analysis and strategic analysis. The outlook obtained from the evaluation is used to calculate a market value for BMW’s equity and the two stock classes. In the financial analysis the following measures were derived: Invested capital, NOPLAT, FCF, ROIC and revenue growth. Moreover the consequences of the past were assessed for the future. Despite the negative development in the above mentioned ratios, the fact that BMW has been able to generate a positive net profit throughout the crisis, yields a positive outlook for the forecast period. The development in the FCF was also positive. It increased to 4,859 mio. € in 2009. The increase in FCF stems from a decrease in invested capital and has a positive impact on the company, since it allows for flexibility in operations. The current WACC was estimated to be 6.69%. The strategic analysis was divided into two parts: External and internal. The external analysis started with outlining the current turbulence in the market. The market was evaluated to be changing but still partly predictable. Afterwards the general environment was described in a PEST analysis. The premium car market in particular was evaluated in Porter’s five forces. After the external analysis was finished off, the internal resources were analyzed. These were analyzed according to the 7S model and finally evaluated against the VRIO Framework. The underlying idea behind performing a strategic analysis was to obtain quantified factors, which could help with the estimation of forecast drivers, in order to get an as accurate forecast as possible. In the external analysis the factors, which were found, have been quantified and put into a time perspective. The quantification was chosen in order to make the strategic factors better comparable. The division of the change in strategic factors between the past, the short- and the long run was undertaken in order to make the strategic factors more usable in the actual forecasting. The PEST analysis concluded that the general environment would have an almost unchanged impact on BMW in the future. The composition of this impact would however have changed, since on one hand socio-cutural factors would yield a more positive influence on the company, whereas on the other economic factors would have a more negative impact. With regards to the analysis of the premium car segment, Porter’s five forces lead to the conclusion that BMW would be impacted more negatively in the future by factors directly attributable to the Page 5 of 93 premium car industry. The negative impact was due to the threat from new potential entrant from emerging markets. The internal analysis concluded the sustainable competitive advantages to be: Branding, Innovative capabilities and the experience with sustainable solutions. In order to combine internal and external factors, key factors of success were looked at. Finally in the strategic analysis, the factors from the internal and external analysis were brought together in a SWOT analysis. The most important strategic factors were combined in order to identify BMW’s strategic position. The critical SWOT analysis concluded that BMW was not in a situation where changes were needed immediately. After the SWOT analysis, the actual valuation was taken care of. First, forecast drivers were estimated on the basis of the strategic and historical analysis. Second the forecast drivers were used to establish values for free cash flows and economic profits. The result of the valuation was a market value for equity of 31,968 mio. €. The equity value was used in a valuation of the two different stock classes. Before the valuation of the stock classes could be undertaken, the price differential between the stock classes was explained. The valuation gave a preferred stock price of 35.70 € and a common stock price of 50.22 €. In order to account for the change in variables, a sensitivity analysis was carried out. The conclusion of the sensitivity analysis was that the equity value is highly sensitive to changes in certain variables and that deviations from the expected values for these variables, would result in a significantly different equity value and corresponding stock prices. In total the result is that if all assumption throughout the report hold, both BMW’s stock classes are undervalued. The preferred stock was undervalued with ca. 12 €, whereas the common stock was undervalued with ca. 18 €. 1.2 Brief introduction The BMW GmbH was founded in 1917 and its first line of business was the production of engines for airplanes. One year later the company became a public corporation. First in the year 1923, when the Versailles peace still prohibited Germany to produce airplane engines, the company launched the production of their first motorcycle. Already in 1926, the company’s common stock was listed on the stock exchange. In 1928, the company grew into a new market through the acquisition of Page 6 of 93 “Eisenach car production” facilities. They started the development of their first small sized car. During the 2nd World War, BMW was heavily involved in the production of engines for airplanes and other war activities. After the 2nd World War the company BMW, how we know it today, started to evolve. The first step was made by the German industrial Herbert Quandt, who bought the stock majority of 60%. The capital injection made BMW able to develop their first middle class car and thereby enter the broad market. In the following years things developed quickly and automobiles were becoming the major part of BMW’s operations. For the first time BMW entered the luxurious automobile segment in 1951, where they launched the BMW 501. In 1989, the BMW Group issued preferred stock for the first time (www.bmweducation.co.uk, 2010). In 1994, BMW realized that they could only succeed as a car producer if they could drag on the same economy of scale as their competitors. The acquisition of the Rover Group was therefore a natural step in the business development. Contrary to BMW’s expectations, the acquisition of the Rover Group proved to be a big failure. The models were out fashioned and the expected sales figures were therefore never reached. During the years after 1994 the British Pound increased by 25%, which made it really costly to serve the loans, which were obtained in British Pounds. In 2000, BMW pulled the emergency brake and partly sold the Rover Group. Land Rover was sold to Ford and Rover was sold to a British investment group for the symbolic amount of 10 Pound Sterling (Guardian, 2009). The only business unit which was kept was Mini. The BMW Group extended their brand portfolio in 2003 through the acquisition of Rolls-Royce. Today BMW is a house of brands consisting of BMW, Mini and Rolls-Royce. Contrary to the beginning, the operations of the BMW Group are now no longer local, but globalised and the strategy is no longer focused at production, but on branding. Page 7 of 93 1.3 Problem statement A major concern for the company still remains its funding of operations. The volatility of company stocks is therefore an issue of interest. Due to the high volatility in stocks, which occurred during the financial crisis, the concern is bigger than ever before. The following figure represents the BMW stocks development since 2005 till 2009. (BMW AR, 2009) The figure above shows a high volatility of BMW’s stock prices over the last years. This volatility makes it difficult for investors to judge whether the stock is at a turning point or has reached a somehow stable level. The aim of this report is to come up with a market value assessment of the BMW Group through the evaluation of strategic- and financial factors. Moreover, it is the aim to explore the differences between preferred- and common stocks. Hence, the research question of this report becomes: What is the market value of BMW’s equity and its two stock types? It is not the purpose of this report to calculate a market value, which is identical to the market price on the cut off date. Instead this report establishes a market value, which is based on a reasonable choice of factors and assumptions. In order to answer the research question the following supportive questions will be answered: Historical financial analysis What has BMW’s net operating profit less adjusted taxes (NOPLAT) and invested capital been over the last 5 years? What return on invested capital (ROIC) does BMW earn on its operating activities? Page 8 of 93  What is the company’s weighted average cost of capital (WACC)? Strategic analysis Which external threats does the company face, how serious are these and how should the company cope with them? How exploitable are BMW’s external opportunities and how should they make the best use of them? Which strengths does BMW possess and how can they be used most effectively? How should BMW deal with its internal weaknesses? Valuation What is BMW’s market value and stock price? How sensitive is BMW´s market value and stock price to changes in variables? How can the price difference between common- and preferred stocks be explained? 1.4 Structure The structure is outlined in order to help the reader to approach the report in the right way; moreover the reader will be told why the given structure was chosen. The authors have chosen to visualize the structure in Appendix 1, which can be found in the back of the report. The report is divided into four parts; Introduction, historical analysis, strategic analysis and valuation. The reader has already been introduced to the company in the brief introduction. This was done in order to familiarize the reader with the discussed company and provide the foundation for the rest of the report. After the brief introduction, the reader was exposed to the problem statement, which is structured with an overall research question and with several supporting sub questions. When having read about the structure, the next chapter is about assumptions and delimitations. The introduction ends with a part about the methods applied throughout this report and the reasoning behind the choice of methods. The historical analysis is performed in order to find the economic performance for BMW rather than the accounting performance, which is given by the company statements. The rearranging of financial statements, when performed correctly, makes the writer able to find invested capital, NOPLAT, Free Cash Flow, ROIC, reinvestment ratios and revenue growth. Finally, BMW’s cost of Page 9 of 93 capital is estimated. The cost of capital (WACC) will in the valuation part be used on a static WACC basis and hence be very important for the calculation of BMW’s company value. The environment and the industry are covered through an external analysis, whereas an internal analysis is used for the evaluation of the company’s resources. The strategic analysis will not only account for the past five years, but also make a forecast of the future. This forecasting is divided into two periods. One being from 2009-2014 (short run), the other ranging from 2015-2024 (medium/long run). The reason for dividing the analysis into three time periods is applicability to the later valuation, which is divided into similar time periods. Moreover, the analysis of the past five years gives a good idea about the strategic issues in the last years and hence help to forecast and perspective the real impact of certain issues. The writers hope to account more realistically for the impact of strategic issues on the company through the comparison of certain issues in the past. The strategic analysis is summed up in a critical SWOT analysis, where different factors are graded and combined. The grading portrays the importance of a factor for the company and helps to identify extremes or trends in strengths, weaknesses, opportunities and threats. The combination of different factors, which are interconnected, enables an assessment of BMW’s need to change. BMW’s need to change is divided into three categories: areas for the need of change in the long-run, opportunities exploitable right away and serious threats. Lastly, the actual valuation is performed. First forecast drivers are found and forecasted according to the historical- and strategic analysis. Afterwards the forecast drivers are used to estimate the company value both through the usage of a discounted cash flow (DCF) and an economic value added (EVA) model. In order to account for the impact of changes in key variables, a sensitivity analysis is undertaken. Finally, the difference between the two stock classes is evaluated from a theoretical perspective. 1.5 Delimitations and assumptions Delimitations and assumptions have been chosen to put a reasonable limit to the analysis and prohibit illegitimate generalizations. The methods are not all discussed in detail, because a certain level of beforehand knowledge is assumed. The financial data has mostly been obtained through BMW’s annual reports, Bloomberg and the Page 10 of 93 program DataStream. These three sources are all assumed to be of high quality and hence no adjustments have been undertaken concerning the data. The cut-off date for gathering additional information was the 17th of March 2010, which was the date for BMW presentation of their 2009 annual report. The historical financial analysis does only cover the most recent five years. This is of course not the ideal case, because such short time estimates can lead to biased data, where trends and unusual data cannot be filtered out and analyzed. The reasons for only choosing the period from 2005-2009 are the major financial implications on the BMW Group incurred in 2004, where Rover was sold. Moreover, the reporting period before 2005 changes many accounting principles, which makes it hard to compare accounts and numbers between years. The uncertainty with regard to the content of certain accounts was estimated to be too high and hence the authors have chosen to go more in depth with other issues. According to BMW’s annual report of 2009, BMW operates after a certain target Debt to company value (D/V) ratio. This implies that the capital structure of BMW will not change significantly in the future. For this reason a static WACC has been used throughout the valuation. The BMW Group is analyzed with the main focus on their automobile business, because this is their main revenue source with about 98%. The financial department almost totally is a product of the automobile activities, where financing is needed. The peer group has been analyzed under the same conditions, so the revenue and sales correspond to the automobile segment. An important assumption is BMW’s strategy to keep a target D/V ratio. This intention is stated in all of their annual reports, but no exact D/V is mentioned. The target D/V ratio for the BMW Group is assumed to be at 60%, because this is close to their D/V ratio in the years before the financial crisis set in. In the forecasting it is assumed that the past five years give a good and truthful starting point for the estimation of the forecast drivers. The forecast drivers are assumed to depend on the period and years before the actual forecast and hence no abnormal values are found among the value driver forecasts. The stable state is assumingly reached in year 2025, where many markets worldwide are mature and growth declining. A prerequisite for calculating the continuing value of BMW operations is the assumption that BMW will live up to the going concern principle and continue their operations indefinitely. Page 11 of 93 A core assumption for this report is that the authors, based on the financial and strategic analysis, are able to estimate forecast drivers, which correspond to the future. A more general assumption is the efficiency of capital markets. This is an important assumption in crisis and post crisis times, where investors might be lead by necessities. A necessity might for example be an investor’s need for money, which can lead to a sale even though the investor is aware that the share is sold below its actual fair value. 1.6 Methods Methods from many different areas are used in this report. In the historical analysis, definitions from finance are used in order to find the economic performance rather than the accounting performance of the company. In the calculation of the WACC, regression analysis is used to calculate a Beta value. In the strategic analysis a degree of turbulence analysis was used to assess the environments likelihood to change and the predictability of market outcomes. Afterwards, a PEST and a SWOT analysis are used to find out something more concrete about the environment. More methods from the area of strategic management, like those three just mentioned, are used in the internal analysis. Here McKinsey’s 7s model and the VRIO Framework are used to find and evaluate internal resources. The strategic analysis is finally summed up in a KFS and a SWOT analysis. After the prerequisites for the forecasting have been dealt with in the strategic analysis, the forecasting is carried out. The main driver in forecasting, which is revenue growth, is validated with the help of statistical analysis. Finally, the valuation methods DCF and ECA methods are used to calculate the equity value. The reasoning for the choice of certain methods in the different analysis parts, will be given along the application of the respective methods. Hopefully, this will create a better connection between methods, assumptions and the application if methods, than would otherwise be obtained. The literature used in this report is mainly taken from scientific books, newspaper articles, reliable internet sources, annual reports and databases. The option of including qualitative data in the form of interviews has been evaluated not to be necessary, because it would probably only slightly contribute to a more precise market value. On the basis of only a small contribution of qualitative research to the market value assessment of BMW, the writers chose not to include it. Page 12 of 93 2 Historical Financial analysis The following historical analysis will be based on the chapter “Analyzing historical performance” from “Valuation” by Tim Koller. The purpose of analyzing the historical performance of the BMW Group is to assess the company’s historical performance, its competitive position and its ability to generate cash flows in the future (Koller, 2005). In order to do so, the following measures will be derived through a reorganization of the financial statements: Net operating profit less adjusted taxes (NOPLAT), return on invested capital (ROIC) and finally the free cash flow (FCF). The overall idea behind the reorganization of the financial statements is to reflect economic profit rather than accounting profit. In a financial statement issued by the BMW Group operating and non operating performance will be mixed together and hence confuse the picture of the BMW Group’s economic profitability. It is the purpose to identify the operating items, so these can be analyzed. The operating items have to be independent of financial leverage and hence reflect the operating performance of the company. Before starting the analysis it is important to make sure that the numbers given in the financial statements from the years 2005-2009 are comparable in terms of accounting standards, since a deviation can cause misinterpretation. The BMW Group has because of its international outlook and its interest in foreign investors been reporting according to IFRS standards for several years. The first change, imposed by the IASB, which changes BMW’s accounting visibly occurs in 2009. In 2009 BMW starts to treat R&D costs as part of cost of goods sold instead of as a separate entry (BMW Annual report 2009). However the change does not impact the size of R&D expenditure, so there is no need for retrospective corrections of financial statements. 2.1 Rearranging the balance sheet - analyzing invested capital There are two roads to invested capital. The operating way goes over operating liabilities, which are subtracted from operating assets; the financing way equals debt plus equity. The operating way will be used in this report. Page 13 of 93 Table 2-1 - Invested capital all numbers 2005 2006 2007 2008 2009 are given in mio. € Invested 38.180 41.017 47.167 52.953 51.683 capital (excl. Goodwill) Invested 42.773 46.329 52.837 58.594 57.062 capital (incl. Goodwill) (source: own calculations) The figure above shows that BMW is increasing its investments until year 2009, where investments decline. The decline in investments in year 2009 reflects the decline in revenue and overall profitability. The area where most invested capital was saved from 2008 to 2009 was inventories. In this area BMW managed to bring down there inventory holding and hence free some invested capital. 2.2 Rearranging the income statement – analyzing NOPLAT NOPLAT should reflect the income from all operations, which is available to all investors. Moreover, there should be consistency between the calculation of invested capital and NOPLAT, so the same entries are found both places. Below is given the NOPLAT numbers for 2005-2009 for the BMW Group. Table 2-2 - NOPLAT all numbers 2005 2006 2007 2008 2009 are given in mio. € NOPLAT 3.717 3.915 4.381 2.129 1.253 (Source: Own Calculations) The NOPLAT calculation gives a good overview of the historical profitability of the company. BMW is at a current down, which is caused by the financial crisis. Consumers are demanding fewer cars than previously and this is having a big impact on the whole industry. The crisis is having an especially big impact on the car industry, because car purchases often can be postponed. The NOPLAT of BMW topped in 2007 with a record breaking result of €4,381 million. The high Page 14 of 93 NOPLAT in 2007 was due to record high revenue and an increase in deferred tax liabilities (Annual report 2007). In conclusion the NOPLAT is very dependent on the external economic conditions. The fact that BMW made it through the very hard crisis years 2008 and 2009, must be seen as a positive thing when evaluating BMW’s ability to grow its NOPLAT. 2.3 Analyzing the Free Cash Flow The Free Cash flow (FCF) represents the amount of cash available to both equity owners and debt holders. Through the calculations of NOPLAT and invested capital it is assured that the now found FCF is neither affected by non-operating nor financing items. In order to understand the FCF fully, one has to decompose it into gross cash flow and gross investment. The gross cash flow stands for the cash flow generated by the company’s operations. Moreover, it represents the cash flow available for investments and for payout to investors. More capital for investment and for payout to investors could of course be created by the selling of non-operating assets or the raising of additional debt. This is however not part of the free cash flow. Much of the current standing of the company is reflected within its gross investments, since these represent the amount being spent on new investments. Table 2-3 below, outlines BMW FCF development over the historical period. The numbers for 2007 and 2008 stick out, because in these years BMW has invested more than they actually earned on their operations. In 2009 the BMW Group has been able to reverse by freeing invested capital and thereby enhancing the free cash flow. The higher free cash flow enables BMW to gain a higher flexibility when planning and arranging their operations. Table 2-3 - Free Cash Flow all numbers 2006 2007 2008 2009 are given in mio. € Gross Cash 6.228 6.852 4.504 3.513 flow Gross -5.009 -7.262 -5.966 1.346 investment Free Cash 1.219 -410 -1.462 4.859 Flow (source: own calculations) Page 15 of 93 A key figure in connection to the free cash flow is the reinvestment ratio, which indicates if the company is growing, how fast it is growing or if it is scaling down its operations. 2.4 Reinvestment ratios The reinvestment ratio is obtained by dividing gross investments by the gross cash flow. In 2007 and 2008 BMW was still riding on the wave of record braking sales, with big investments in inventory and a big amount of outstanding receivables. In 2009 BMW for the first time got a positive reinvestment ratio. This means that BMW has actually derived capital from earlier operations. The capital is mainly derived from smaller investments in financial leases, but also from disposals of property, plant and equipment. Table 2-4- Reinvestment ratios 2006 2007 2008 2009 Reinvestment -80,42% -105,98% -132,46% 38,31% ratios (Source: own calculations) 2.5 Return on invested capital (ROIC) ROIC is derived by finding the ratio of NOPLAT to invested capital. The NOPLAT numbers found previously will be used, but the invested capital will be recalculated in order to reflect the average usage of invested capital and not just the ending usage of capital during a specific year. Other measures, which could have been used when looking at invested capital, are ROE and ROA. Both measures are affected by the company’s capital structure and hence not so good indicators of the company’s core performance (Koller, 2005). It is important to find both ROIC including goodwill and excluding goodwill. The first will be interesting for shareholders, who want to get their payoff from capital invested also in intangible resources. This means that investors can compare the ROIC to the company’s WACC or their own cost of capital and then decide whether the company’s operation adds any value. Only if the company’s ROIC lies above or on its WACC, value is earned or added otherwise value will be destroyed (Koller, 2005). Contrary, ROIC excluding goodwill is a good measure for comparing companies’ internal performance, since it concentrates on the core operations of the company and neglects intangible assets (Koller, 2005). Page 16 of 93 Table 2-5 - ROIC 2006 2007 2008 2009 ROIC excl. 9,55% 9,29% 4,02% 2,42% Goodwill ROIC incl. 8,45% 8,29% 3,63% 2,20% Goodwill (Source: Own Calculations) According to the figure above, the company is facing a hard time covering their invested capital. Both ROIC including and excluding goodwill give the same picture; the company has a significantly declining ROIC since 2007. This can be explained through the sharp decrease in NOPLAT, whereas the invested capital has remained almost unchanged. BMW has been unable to respond to the decline in sales caused by the financial crisis. Their cost og goods sold (COGS) are almost identical throughout 2007 to 2009, whereas their sales have been declining by 3,000 mio. € per year. 2.6 Analysis of revenue growth During the recent two years BMW has not been able to sustain its earlier revenue growth. Revenue for 2008 and 2009 is however still larger than 2006. Since 2007, where BMW’s revenue peaked with 56,018 million €, revenue has been declining, in 2008 and 2009, with 5% and 4.7%, respectively. The revenue generated by the company’s three divisions has changed in the last years. Remarkably is the increasing importance of the financial division, which since 2005 has grown its generation of total company revenue from 20% to 31.1% (BMW annual reports).Geographically seen, revenue is also undergoing some changes; Asian markets are representing a continuously increasing part of total company revenue. Revenue can however be distorted by several things. The prime three things are: Currency changes, mergers and acquisition and changes in accounting policies. During the analyzed historical period, BMW has neither experienced any significant changes in accounting standards nor made any major acquisitions. The change in accounting policies is assessed to be insignificant, since this is done so by BMW in their annual reports (BMW AR, 2009). Currency risk is however an area, where BMW has been exposed to operating, transaction and translation exposure (Moffett, 2009). Transaction has in the past been the major concern for the BMW Group, since many cars were produced in Europe and then exported to other markets, which meant that revenue was obtained in one currency and expenditure in another. This is especially the case for the brands Mini and Rolls Page 17 of 93 Royce, since these are only produced in Great Britain. The focus on bringing down transaction exposure through the establishment of world-wide production facilities has however exposed BMW to more translation and operating exposure. In order to assess the real revenue growth of the BMW Group it is necessary to look at changes in exchange rates and their interest in different currencies. Currency changes had the following impact on the BMW Group during the last five years: Table 2-6 - exchange rate impact numbers in mio. € 2009 2008 2007 2006 2005 Exchange rate impact -51 178 -46 82 66 (Source: BMW Annual Report) In 2007 and 2009 exchange rates had a negative impact on the BMW Group, where 2005-2006 and 2008 had positive effects for the Group. 2.7 Capital Structure – Optimal Capital Structure When valuing a company it is important to find out how invested capital was obtained. In order to ensure a sustainable capital structure the company must strike a reasonable balance between debt and equity financing. If the company would be solely equity financed, the company would forgo a tax shield which could be obtained through the carriage of debt. Contrary, a company, which is relying heavily on debt financing, will destroy value after a certain level of debt to the total company value. This point, where a deviation would lead to value destruction is a desired target for many companies. If a company carries more debt than the ideal debt level it incurs financial distress, where investors will adjust their demand for return upwards and hence create a situation, where the upward adjustment of demanded return will eat up the tax shield created by the additional debt obtained by the company. The credit health of the BMW Group will be analyzed by looking at the two factors: Liquidity and leverage. Liquidity is defined as the company’s ability to meet short term obligations; contrary, leverage represents the company’s ability to meet long term obligations in the future. BMW’s liquidity can be measured by taking the ratio of current debt to current liabilities. It will only be looked at this ratio in a historical perspective, because a peer group analysis is not considered value adding in this context. Page 18 of 93 Table 2-7 - BMW's Liquidity in mio € 2005 2006 2007 2008 2009 current assets 27.010 28.543 32.378 38.670 39.944 current 17.838 17.656 22.493 29.887 26.934 liabilities Current 1,51 1,62 1,44 1,29 1,48 assets/current liabilities (Source: Own Calculations) 2.7.1 Financial Leverage Leverage is in the wake of the financial crisis probably a better measure for the company’s credit health. Liquidity is a good measure during times of crisis, where it is important to have a flexible capital structure and be able to react immediately to market stimulus. However, in times of recovery and more stable market growth, which is predicted for the coming years, the long-term perspective of leverage might be a better measure. The leverage is estimated by comparing BMW’s Debt to market value of equity over the analysis period. Further BMW’s Debt to market value of its equity will be compared to its competitors. Table 2-8 - BMW's Leverage 2005 2006 2007 2008 2009 Debt 34.668 36.456 43.921 60.384 61.325 Equity 24.776 28.464 27.389 13.733 21.281 Debt/Equity 139,93% 128,08% 160,36% 439,70% 288,17% Debt/Value 58,32% 56,16% 61,59% 81,47% 74,24% (Source: own calculations) BMW’s historical leverage has been suffering during the financial crisis, with an increased amount of debt to equity. This however was characteristic for the overall market at the moment and should not be seen as a sign of weakness. Page 19 of 93 Table 2-9 - Peer Group leverage year 2009 Debt Equity Debt/Equity Debt/Value BMW 61.325 21.281 288,17% 74,24% Mercedes 58.294 38.670 150,75% 60,12% VW 77.599 12.375 627,09% 86,25% Ford 132.441 44.020 300,86% 75,05% Peer Group 341,72% 73,91% Average (Source: Own calculations) The peer group leverage average is distorted by the enormous debt to equity ratio of VW. BMW’s is lying below the average leverage, which means that BMW with its current outlook has a good position to service its long term obligations. 2.8 Peer group financial ratios The peer group ratios should be seen as a starting point for the strategic analysis. It derives some of the key financial ratios among BMW’s competitors in the automobile industry and hence gives a good starting point for further analysis. The ratios below will be dealt with in more detail during the strategic analysis. Table 2-10 - Peer Group financial ratios in mio. € BMW Mercedes VW Ford Revenue 50.681 78.924 105.187 118.308 R&D 2.448 4.181 3.000 4.900 COGS -42.908 -65.567 -91.608 -100.016 Net profit 210 -2.644 911 2.717 cars sold 1.286.310 1.093.905 6.309.743 x R&D/revenue 4,83% 5,30% 2,85% 4,14% COGS/Revenue -84,66% -83,08% -87,09% -84,54% Net profit /Cars 0,0001632577 -0,0024170289 0,0001443799 x sold (Qty) Working Cash / 15.33% 12.42% 18.12% 19.53% Revenue Brands BMW, Mini, Rolls Daimler-Benz VW, Audi, Seat, Ford, Lincoln, Royce Mercedes, Smart, Skoda, Mercury Maybach Lamborghini, Bentley, Bugatti (Source: Own calculation based on annual reports from the respective companies) The x in the figure indicates that a number could not be obtained from the annual report of the corresponding company. Page 20 of 93 2.9 Conclusion on the Financial Analysis As shown in the financial analysis, BMW has been hit hard by the financial crisis. Especially with regards to revenue which has dropped significantly during the crisis. Consequently, NOPLAT dropped during the crisis and is now at a low level compared to the level before the crisis. This will assumingly improve as the economy begins to stabilize in the future. Despite the negative development in almost all key numbers, like ROIC, NOPLAT etc., the fact that BMW has been able to generate a positive net profit throughout the crisis, yields a positive outlook for the forecast period. The development in the FCF was also positive. It increased to 4,859 mio. € in 2009. The increase in FCF stems from a decrease in invested capital and has a positive impact on the company, since it allows for flexibility in operations. The fact that BMW made it through the crisis without getting into any severe trouble with regards to liquidity and net profit, gives BMW a strong position, when the market recovers fully. 3 The Cost of Capital The valuation of BMW is based on discounting future free cash flows and economic profit. However, these must be measured against something in order to ensure that the investment will be better than investing in another asset with similar risk. The weighted average cost of capital or WACC is a measure of this opportunity cost that investors face when investing in any asset. In its most simple form the WACC looks like the following (Koller et.al., 2005, p. 292): Where; D/V, Ec/V & Ep/V = the weights of debt, common and preferred equity, respectively, to enterprise market value. T = the company’s marginal income tax rate kd, kec & kep = the cost of debt and equity respectively. The following sections will be going through the steps of estimating the different measures needed to calculate the WACC. In each section results will be presented and decisions will be reasoned for. Finally the results are summed in a conclusion arriving at an appropriate WACC. 3.1 Estimating Market Value Weights & Tax A critical component of the WACC is the weights which are given to the different funding sources since they determine the impact of the different cost measures on the WACC. The weights should be based on market values and not book values (Koller et. Al, 2005, p. 322). BMW is operating Page 21 of 93 with a target debt to value ratio (BMW AR, 2009). They do however not disclose the exact target debt to value ratio. 3.1.1 Market Value Weights To determine the market value of BMW’s equity number of common shares is multiplied by their respective market price and the same has been done for the preferred stock class. This is part of the calculations in table 3-1. This table shows the portion that the entire equity represents of market value. The equity weight has been further decomposed in order to obtain the weighting that is used for the two different stock classes. Table 3-1 shows the weights disclosed in the BMW financial report as well as estimations based on the financial reports. Table 3-1 - Market Value Weights 2004 2005 2006 2007 2008 2009 Average Own Calculation based on market share prices of 30.3.2010 E/V 42% 42% 44% 38% 19% 25% 35% D/V 58% 58% 56% 62% 81% 75% 65% BMW disclosed figures: E/V 35% 33% 34% 33% 25% 25% 31% D/V 65% 67% 66% 67% 75% 75% 69% (Source: BMW financial reports 2005-2009 and own calculations based on the reports) The two stock classes are assumed to maintain their relative share of total equity throughout the forecasting period. The weight of the two classes is based on the figures for the financial year ending 31.12.2009. The historical development in the percentage that the two classes make of the total equity can be seen from the below table. 3-2 - The composition of equity Market value of Equity in Percentages Year 2004 2005 2006 2007 2008 2009 Common 94,10% 93,05% 92,02% 93,08% 94,73% 94,05% Preferred 5,90% 6,95% 7,98% 6,92% 5,27% 5,95% (Source: Own calculations) Page 22 of 93 The weight of BMW’s debt is based on the book values, which is a breach of the assumption that the weights should be based on market values. This is however not considered to be of significant importance for the valuation as the book values of debt are considered as good approximation of their current market value. Based on these values the capital structure of BMW is constructed and presented in table 3-1. Based on these results a capital structure for BMW AG of 40% equity to enterprise value was assessed. This corresponds to the average of equity to company value before the financial crisis. This value is chosen as it is expected to be closest to BMW’s target debt ratio. Multiplying the percentages found in table 1.2 for 2009 with the 40% equity weight and the weights for the two different stock classes are used in the market value calculation of equity. This leads to market value weights of 60% for debt, 2.38% for preferred equity and 37.62% for common equity. These values will be used when calculating the WACC at the end of this chapter. 3.1.2 Tax The tax rate chosen is 30%. This is close to the statutory corporate tax rate in Germany of 30.2%. The average effective tax rate for the company over the historical period is found to be 27.3% (own calculations). The tax rate is set just below the statutory tax rate as the company also pays taxes in other countries, where the tax rate is lower. 3.2 Estimating the Cost of Equity In order to estimate the cost of equity, several different methods have been developed. The model favored by practitioners is the capital asset pricing model (CAPM) (Robert F. Bruner et.al., 1998, p. 17). Other models have however also gained acceptance over the years. Some of the better known are the Fama-French three-factor model and the arbitrage pricing theory (APT) (Koller et.al, 2005, p. 294). The Fama-French three factor model has been widely accepted due to its significant validity based on empirical research. The authors of the model, Eugene Fama and Kenneth French, found that the CAPM model was too imprecise in estimating the return on equity. They accuse the CAPM of being insufficiently able to capture all factors with the beta value. They found that the CAPM had a tendency of overestimating the average return on companies with a low market equity value and underestimating the average return on companies with a high market equity value (Fama-French, 1992). Page 23 of 93 The Fama-French three factor model is an attempt to remove this tendency by introducing further two portfolios when estimating a company’s specific beta. The two additional factors are meant to capture the excess return of small stocks over large stocks and the excess return for high book to market stocks over small book to market stocks. This should increase the precision in the calculation of return on equity. Even though the Fama-French three factor model is backed up by empirical research it is still a young model and much has still to be researched on it. Even though it is used increasingly in practice, there is still much doubt about how many data points should be used when calculating the different portfolios (Koller et.al, 2005, p. 317). The APT is a very theoretical model. It is constructed in such a way that all factors, which are influencing a company’s required return on equity, are accounted for and afterwards added to the risk free rate (Koller et.al, 2005, p.317). The main critique of the model is on the practicalities of it. It has not been determined what the factors that influence the return on equity are. Furthermore any deviations from the model will result in arbitrage. The CAPM is chosen, because it is the preferred model among practitioners and furthermore has withstood the test of time, which indicates that it is a strong model. It is noted that the CAPM might be too simple to capture all factors influencing the calculation of return on equity, however it is considered to be of minor importance for the valuation of BMW. 3.3 The CAPM Equation Below is the CAPM equation presented (Koller et. al., 2005, p. 294). As can be seen, the model is split into two. First, the rf, captures the investor’s time value of money. Second, βi[E(Rm) – rf], captures the investor’s risk premium, what he expects to get in return for the risk that he is accepting. In the sections following the equation, the specific factors will be derived for BMW. Where; E(Rm) = the market’s expected return rf = The risk free rate βi = the stocks sensitivity to the market E(Ri) = security i’s expected return It should be noted that the procedure for calculating the required return for preferred and common equity is based on the CAPM. The only difference in the used inputs for the two classes is the beta, which will be specified later. Page 24 of 93 3.3.1 Estimating the Risk Free Rate When estimating the risk free rate most practitioners turn to government treasury bills or bonds (Koller et. al., 2005, p. 296). There is a big difference between the practitioners and the scholars, when estimating the risk free rate. 43% of scholars use a treasury bill as an approximation for the risk free rate, while only 4% of the practitioners do (Robert F. Bruner et.al., 1998, p. 17). The current yield on the 90-day German treasury bill is 0.12% (www.bloomberg.com, 2010). This is extremely low and is caused by the financial crisis, which has forced the central banks to decrease the interest rates in order to boost economy. We choose to use a 10-year government bond as it matches the period of analysis better than a 90-day treasury bill. Several different government bonds were considered. There was doubt about whether an US government bond with a 10-year maturity or a German 10-year Government bond should be used. Since there is very little difference in the two bonds liquidity the German 10 Year government bond is chosen as BMW’s headquarter is located in Munich, Germany. When calculating the risk free rate data was collected on the constant 10-year maturity German Government bond from 1.1.1995 until 1.1.2005. The data was collected quarterly. The development in the 10 year German government is presented in appendix 2. Three different time periods was considered for calculating the risk free rate as the current yield on the 10-year German Government bond is 3.06% (www.bloomberg.com, 2010), this is considered to be too low to be used for the entire forecasting period. The period 1995-2006 was considered as it is believed to be a period of stable market developments and it should give a good indication of the risk free rate in a normal stable market. The time period of 2005-2009 was considered as it was identical to the period of our historical analysis and thereby more closely connected with the historical returns of the company and its performance. Lastly a time period using all data points was considered as was expected to depict the development in the risk free rate in both unstable and stable market conditions. The first period, 1995-2006, was chosen as it is expected that the future markets will be stabilizing and return to a level seen prior to the financial crisis. This corresponds to a risk free rate of 4.97%, which will be used in our future calculations. 3.3.2 Estimating the BMW’s sensitivity to the Market In the following the calculations of the two BMW betas will be presented. Several different simple regression analyses where conducted in order to get a better picture of the betas in connection with different market portfolios. The full regression analysis and calculation on DAX30 for the common Page 25 of 93 stock is presented in appendix 3. The procedure for calculating all the betas is outlined in that appendix. It should, however be noted that the calculation on the other indices where conducted in a similar way. Data was gathered on the development of the BMW common share as well as the development on the different stock indices. These figures were then regressed against each other in a simple regression model, which is introduced in the following. In the estimation of the company’s sensitivity to the market or beta (β) the market model was used (Koller et. al., 2005, p. 306): where; Ri = the % change in BMW’s share price Rm = the % change in the DAX30 index The model is: (Appendix 3) Ri = -0.0053 + 1.0038Rm + ε This means that the estimated beta of BMW on DAX30 Performance. The high-end car segment is probably significantly more affected by macro factors, such as fluctuations in the economy, than company specific factors, such as operating risks, which explains why the beta values are so close to 1. Table 3-3 - Beta values Index Beta Value MSCI – Own Calculation 0.9555 S&P500 – Own Calculation 0.9702 DAX30 Performance – Own Calculation 1.0038 Bloomberg.com – DAX30 1.044 Frankfurt Boerse – DAX30 1.09 (Source: Public Betas from Bloomberg and Frankfurt Boerse, 23-4-2010 and own calculations based on data from DATASTREAM) The Beta calculated on the basis of DAX30 is chosen as a fair estimator, although it seems to be slightly less than those offered by professional services. The same steps were used for the preferred stock class and it yielded a beta equal to 1.07. Page 26 of 93 3.3.3 Estimating the Risk Premium on Stocks The risk premium on stocks, defined as the difference between the return on the market portfolio and the risk free rate, is one of the most debated topics in finance (Koller et. al. 2005, p. 297). The risk premium is the same for all equities. It captures the shocks that all companies are exposed to by being in the market. These shocks normally come from the macro economic factors. Koller et. al. mentions 3 broad categories of estimating risk premium on stocks (Koller et.al, 2005, p. 298). These are: 1. Estimating by measuring historical market excess return Extrapolating the development in government bond vs. stocks 2. Using current market variables to estimate the current market premium Aggregate dividend-to-price ratio which projects the expected market premium 3. Reverse engineer the market premium by means of DCF valuation, based on estimates of Return On Investments and growth The problem associated with using a historical market premium is its dependence on the past. Hence, there is no guarantee that the risk premium of the past will be identical to the risk premium of the future. When using market variables the advantage is that they are grounded in the present and reflect future expectations. It is possible to predict future market premiums by means of regression analysis on dividend yields (Koller et.al., 2005, p. 304). However they have an undesirable possibility of being negative. It is chosen to use an outside source for the risk premium, because estimations are not expected to be more precise. Furthermore no one has yet been able to establish any long-term trend in the market premiums (Koller. et.al., 2005, p. 303), suggesting that the regression of market premiums might not be any more precise than average historical market premiums. Koller suggests a market premium between 4.5% and 5.5% whereas the majority of practitioners use a market premium between 4% and 6% (Bruner et.al., 1998, p. 18), which is very much in line with the estimated values by Koller. These values are based on markets, which are in a stable development and not characterized by great uncertainty. Due to the financial crisis, a 6% risk premium seems reasonable and will therefore be used in the calculations. Page 27 of 93 3.3.4 Conclusion of the CAPM The risk premium, which are given in table 3-4 are evaluated to be the most appropriate values for the return on equity, which could be obtained. The values are therefore used in finding the WACC. Table 3-4 - Calculating Cost of Equity CAPM: Preferred Common Rf 4.97% 4.97% Βi 1.07 1.0038 Rm 8 8 E(Ri) 11.40% 13.00% (source: own calculations) 3.4 Estimating the Cost of Debt BMW is operating with several different types of debt. The majority of this debt comes from corporate bond issues, making up roughly 40% of the company’s total debt. BMW is rated by Moody and Standard & Poor’s rating services. BMW is rated in the investment grade category, which makes it possible to obtain favorable interest rates when issuing corporate bonds. In order for the WACC to achieve its theoretical right value it should have included a weight and cost for each of the different types of debt that BMW makes use of. However, as many of these types of liabilities are not publicly traded or otherwise identifiable as to estimating their cost, the liabilities are treated if they were bonds. This is chosen as the expected gain of treating the debt types individually is expected to have an insignificant impact on the company valuation. Two different ways of estimating BMW’s cost of debt have been utilized. First the information enclosed in the financial statements of BMW was reviewed and second a simple method taken from Koller et. al., 2005, which is based on a spread over the risk free rate. Enclosed in the financial report of 2009 is a comprehensive review of the bond issues, their average maturity and average effective interest rate. After reviewing these bond issues the average interest payment on these loans is calculated to be 4.35%. The cost of debt is expected to increase during the forecasting period, meaning that the found interest rate is probably too low. This is based on two reasons. First, there has been a positive development in the interest rates. They are at their lowest for many years due to the financial crisis, which have forced the central banks to lower the interest rates in order to boost the general economy. Second, the current credit rating of BMW has a negative outlook, meaning that the company is in risk of being downgraded. If the company gets a downgrading it would all other things equal mean that the cost of debt would increase. Page 28 of 93 Another method that could be used is the yield spread over US treasuries. These spreads are calculated by Bloomberg and presented in Koller et. al. on page 320. It has not been possible to obtain spreads, which were more up to date than in the book. The procedure is quite simple though. In order to estimate the company’s cost of debt one takes the risk free rate and adds the spread corresponding to the company’s credit rating. The spread used is the one corresponding to the current credit rating of BMW. This is not corrected though there is a change of further downgrading of the company. With a maturity of 10 years and a credit rating A2/A, the spread is 48 basis points. When this is combined with risk free rate the cost of debt becomes: 4.97% + 48 basis points = 5.45%. Table 3-5 – Cost of Debt Rates Compare to Risk Free Rate Source Interest rate After Tax Rate BMW 4.35% 3.045% Koller et. al/Bloomberg 5.45% 3.815% Corporate Bond 4.23% 2.961% Risk Free rate 4.97% (Source: Own calculations based on data from Datastream, BMW, Koller et.al & Bloomberg ) Table 3-5 gives an overview of the different interest rates that were considered as estimators for the cost of debt. The corporate bond is a corporate bond index calculated by JP Morgan for companies rated A, as BMW is currently. It was included to indicate that the current cost of debt according to the financial statement of 2009 for BMW is not much higher than for other similar companies. The chosen cost of debt, to be used in the calculation of BMW’s WACC, is the interest rate from Koller et. al./Bloomberg. This is chosen as it is considered to fit expectations best possibly in the years to come. This means that the cost of debt becomes 5.45%. 3.5 Conclusion The WACC can be calculated and it will be presented in the following table. Table 3-6 - Calculating the WACC WACC Page 29 of 93 D/V 60% Ec/V 37.62% Ep/V 2.38% kd 5.45% T 30% Kec 13.00% Kep 11.40% WACC 6.69476% (source: own calculations) As can be seen from the table 3-6, the WACC is calculated to be 6.69476%. This WACC is evaluated to represent BMW’s current cost of capital most precisely and hence it will be used in the valuation to discount back cash flows and economic profit. Page 30 of 93 4 External Strategic analysis The following pages will deal with the environment of BMW. The more general environment will be analyzed according to the PEST model. In order to capture how the environment is changing the Degree of Turbulence (DOT) model will be used. The concrete industry will be analyzed by using Porter’s Five Forces analysis. 4.1 The Degree of Turbulence For the strategic analysis of the environment it is crucial to find out how turbulent the industry at the moment is. This is especially important, when considering whether the company should follow an emergent or prescriptive approach in terms of strategy choice. The result of this analysis is quantified on a scale from 1 to 5; 1 being least turbulent and 5 – being very turbulent (Appendix 4). The two central factors determining the turbulence in the environment are changeability and predictability (Ansoff, 1990). The changeability is defined through the likelihood of the environment to change. It is further composed into two factors: “Complexity” and “Novelty”. “Complexity” represent the impact of factors such as political, technological and social complications. With regards to complexity, the BMW Group is affected to a “global economic” extent, since they have world-wide operations and world GDP, commodity prices and the change in technology will have a big impact on their success. “Novelty” determines how often the environment yields new situations for the company. The BMW Group is assessed to be somewhere between “extrapolable” and “discontinuous familiar” with events. On one hand BMW is in a high technology industry, where innovations can turn the market up side down, but on the other hand, all businesses within the industry know how important technology is. The predictability defines to which degree the changes, which were presented above, can be determined. Predictability can be decomposed into the “rapidity of change”, which ranges from fast to slow and the “visibility of the future”, which relates to the availability and quality of the information used to predict the future. The “rapidity of change” is evaluated to be between “slower than response” and “comparable to response”, because changes in e.g. GDP of a country will most likely lead to a change in the amount of premium cars demanded. However, BMW’s position as a price taker in the acquisition of commodities can easily affect their profit margin on cars and hence their bottom line result. With respect to the “visibility of the future”, the future is assessed to be “forecastable”. Changes in the factors, which are important to BMW are “forecastable”, i.e. BMW Page 31 of 93 is able to act accordingly. The industry participants all know that the trend is going towards environmental friendly cars, which implies that it is forecastable to say where the market is going. According to the DOT analysis, the environment obtains a score of 3. Consequently, the environment is “changing” and there is a need for continuous adjustments to the preliminary strategy by the BMW Group. Accordingly, the following strategic analysis will focus on the prescriptive approach, but also emphasize that there might be some changes in factors. 4.2 PEST A PEST analysis stands for: Political-, economic-, socio-cultural- and technological factors. These areas are listed, analyzed and related to the BMW Group. The purpose of this is to get an impression of how the environment is going to change in the future (Lynch 2009). However, it must be kept in mind that a PEST analysis first and foremost builds on historical data. As previously mentioned in the degree of turbulence analysis, the environment gets a rating of 3, which means it is likely to change. Hence, it becomes more difficult to predict the future from past events. Further it must be acknowledged that the results from the PEST analysis are not directly transferable to the future. For this reason, the factors in the PEST analysis will be divided into three time periods. The first being an analysis of past events (the last 5 years), corresponding to the historical financial analysis. The last two time periods deal with the future. In order to predict the future accurately, the analysis is divided into the short run and the long run. Lastly, the factors will be quantified on a scale from 1 to 5 (1 being the most favorable for BMW). This should simplify the comparison between factors and further make past and future events comparable (Appendix 5). When applying too many factors, a PEST analysis can easily become confusing and irrelevant. The purpose of the following analysis is therefore to focus on the most relevant factors and describe them in detail. 4.2.1 Political factors In the past one political factor has lead to several obstacles for BMW. This namely is the enforcement of new laws. The areas, which at the moment are debated the most, are the emission of CO2 and the end-of-life vehicles directive (www.environment-agency.gov.uk, 2010). Tighter emission standards are on the agenda all over the globe, especially in OECD countries. It is not just a matter of national legislation; also some city areas are restricting CO2 emission (www.umwelt-plakette.de, 2010). Europe, which accounts for 50% of BMW’s total revenue, has Page 32 of 93 had similar standards for several years. The current standard, the EURO 5, was enforced on the 1st of September 2009. It prescribes the car manufacturers to follow certain norms and further makes the manufacturers liable for the performance of the car for 5 years or the first 100.000 km (www.ec.europa.eu, 2010) Also BMW’s second largest market, the US, is enforcing emission regulations in certain areas. The emission restrictions can easily increase costs in the areas of development, testing and manufacturing for BMW. Another hot issue, where the EU is the forerunner, are ELV directives, which dictate how the end- of-life vehicles (ELV) should be recycled. Further the directives state that the car manufacturer is obliged to take back components as: airbags, shredder residue and fluorocarbon. The directive poses additional costs on BMW, since they will have to take the recyclability of the car components into account and the cost of scraping the components they receive after ended life of the car (EU directive). BMW has reacted on this directive and is now manufacturing cars, which are at least 85% recyclable and at least up to 95% recoverable (Group Management report 2008, p. 32). Even though BMW has been able to cope with the new directives in the past, newer and more stringent directives remain a threat to the company in the future. BMW should however come easier about the more stringent directives than competitors, since they continually try to beat the industry in terms of sustainability (www.sustainabilityindex.com , 2010). The last, but not less important political factor, is the political (in)stability in emerging markets. This area is of great importance to BMW, since these markets take up a larger part of total revenue (Group Management Report, p. 15). Moreover, these markets represent the future growth prospects for BMW. Emerging markets currently deliver about 13% of total revenue. (Own calculations of p. 15 – Annual report) Political instability can lead to very different outcomes, but common for them is the negative impact on BMW’s bottom line. In the future the operations of BMW in emerging markets will increase, hence a increase in the dependency on political stability will occur. 4.2.2 Economic factors The world GDP growth has been fluctuating a lot in the past years. In 2008 the market contracted with a decline in GDP of 2.6%. In 2009 however, world GDP grew by 1.6%. The projections for 2010 is a growth in GDP of 2.5% (IMF, 2009).This leads to the suggestion that the world economy is about to recover from the financial crisis. Projections for the years from 2011-2025 predict world GDP to increase steadily by 3.5%. For BMW’s operations it seems relevant to distinguish between the growth in emerging markets like China and India and the growth in Western economies Page 33 of 93 like Europe and the US. The prospects for China and India are a GDP growth of 4.7% and 6.2% respectively, whereas the US and Europe grow by 2.2% and 1.8% respectively (Duval 2010). In the wake of the financial crisis there is a huge awareness for the credit risk associated with especially debt financing. BMW therefore finances its activities by matching the maturities of bonds to their activities. They further rely on derivatives to hedge for the interest rate risk (BMW AR, 2008). Even though interest rates are historically low at the moment they are expected to rise in the future (www.bluechip.com, 2009). BMW has two ways of reducing its currency risk exposure. One way is by natural hedging; BMW has production facilities in its major markets. Having production facilities located in the countries where revenue is generated means that BMW is able to spend the revenue in the same currency, hence reducing their currency risk. However these production facilities are specialized, so not every car model is produced everywhere. This means that BMW will not be able to perfectly match its revenue with its costs. At the moment BMW is exposed to the biggest currency risk from US dollar, British Pound, Japanese Yen and Chinese Renminbi. They in total account for 65% of BMW’s total currency exposure. When BMW settles a deal in a foreign currency, they immediately conclude a exchange rate hedge to eliminate the risk (BMW AR, 2008). The main hedging takes place between Euro and US Dollar, since BMW has a large revenue from its US operations, but not correspondingly high costs. The current weak Euro makes the exchange rates to a major concern for BMW. Due to BMW’s continuous globalization , currency risk exposure will remain an important topic for the BMW Group in the future. BMW’s cost of manufacturing are to a very big extent determined through the cost of raw materials, which are used for the production of cars and motorcycles. The most used raw materials are by far steel and aluminum. These fluctuate a lot in price, which means that BMW has difficulties in predicting the future prices and therefore has the risk of under pricing their products and earning less than desired on their products or maybe even incurring losses (BMW AR, 2008). The prices on aluminum and steel have risen over the last years (www.metalprices.com , 2010) and for April 2010 experts expect the price of steel to increase by further 10-15% (www.economictimes.com, 2010).In order to counteract the volatility in raw material prices, BMW hedges. They have further centralized their purchases of raw materials, so they now can rely on the synergies created by mutual acquisitions (BMW AR, 2008). Due to the limited access to raw Page 34 of 93 materials and the increasing demand by emerging economies, the price of raw materials is expected to rise in the future. The price of crude oil is another major determinant for the economic outlook of the BMW Group. The price of crude oil is both reflected in the price of manufacturing and in the demand for products. An increase in the price of crude oil will therefore have a double negative effect. Just as with the price of raw materials, the price of crude oil must be expected to rise in the future, due to the increased demand from emerging markets. 4.2.3 Socio-cultural factors The demographics of the emerging markets are yielding new opportunities to BMW. The middle- class in countries like India and China is growing continuously and hence new big target segments evolve (www.euromonitor.com, 2010). In BMW’s existing markets, concern for the environment plays a more and more important role. Especially consumers in the US and Europe demand “green” products, which live up to emission standards and environmental directives. BMW’s reaction to their customers’ change in preferences, becomes evident, in BMW’s increased focus on hybrid cars, dual fuel engines and in general more fuel efficient cars. BMW has also produced 500 hydrogen cars, which have been handed over to the customer on a trial basis (BMW AR, 2008). At the Climate Conference in Copenhagen BMW sponsored several vehicles with low CO2 emission (www.pressebox.com, 2010). Through its focus on green driving, the BMW Group achieved to be the market leader on the Dow Jones sustainability index (www.sustainabilityindex.com, 2010). In the long run BMW is expected to remain at the forefront of sustainability by providing innovative solutions to environmental issues. 4.2.4 Technological factors A recent survey of top managers in the automobile industry revealed what they considered the top issues for the future. 85% of respondents answered that technology is the top priority (Automotivenews, 2010). This leads to the conclusion that technology is an area where it is difficult to gain a competitive advantage. Even though competition is fierce, BMW managed to get an advantage in the production of engines, which lead them to win several “engine of the year awards” (BMW AR, 2009). The increased focus on environmental issues is creating possibilities for the development of environmental friendly solutions within the area of transportation. As already mentioned BMW has a good position, because BMW has researched in this area for years, by Page 35 of 93 researching dual fuel engines, hybrid electric cars and hydrogen driven cars. When talking about technology and R&D it is not just important to be innovative and have the “best” technology, it is just as essential to be perceived by customers as the most innovative. This point was emphasized by Thomas Weber (Daimler’s head of development), when he acknowledged that Daimler is beginning to catch up on BMW in terms of technology, but is still lacking behind in terms of public perception (www.chinadaily.cn, 2010). In the short run BMW will as a response to the current situation cut costs in research and development, but in the long run they are expected to expand their activities within R&D and keep their focus on technology (www.bmwgroup.com, 2010). 4.2.5 Conclusion of the PEST analysis The PEST analysis suggest that there is a continuous improvement for BMW in terms of external impact on the organization. The relevancy of each factor for the future was considered equal across the four external factors. This might however be doubtful, since the economic factors will have the most direct effect on BMW’s performance. The enforcement of new laws and the political instability in emerging markets are the main political factors. Several economic factors are identified, because they are assessed to have the most direct effect on BMW profitability. The biggest threats are interest rate risk, currency risk and increasing raw material prices. Contrary, the predicted increase in GDP is an opportunity, which could help BMW to increase its revenue. The most important socio-cultural factors for BMW are the growing middle class in emerging economies and the increasing demand for “green” products. Within technologies, innovation in the area of sustainable solutions, is evaluated to be the most important issue for BMW. There are of course other factors, which have not been specified in the PEST analysis. These have been left out in order to focus on the most relevant factors impacting the development of the company. Consequently, the PEST analysis should only be seen as a guideline for the future development; not an concise description of all factors. According to table 4-1, BMW is facing an overall importance of general environmental factor in the future. The composition does however change. In the future socio-cultural factors are more positive for BMW, whereas economic factors have a negative impact on the company. The positive outlook in terms of socio-cultural factors can be explained to the expected increased demand for “green” products in the future. The negative economic outlook is associated with the increase in raw material prices. Page 36 of 93 Table 4-1 - PEST summary PEST overview Past Short run Long run Political factors 2.5 2.5 2.5 Economic factors 2.4 3 3.4 Socio-cultural factors 3 2 1.5 Technological factors 2 2 2 Grand average 2.475 2.375 2.35 4.3 Porter ‘s 5 forces The Porter’s 5 Forces is often used as a model for describing an industry. The model is very useful in describing the relation between the company in focus, its competitors and its suppliers. The 5 forces of the model are: Potential entrants, buyers, suppliers, substitute products and industry rivalry. The model works by assessing each of these categories and their relative power in relation to the focal company. For each of the 5 forces, opportunities and threats have been quantified (Appendix 6). This has been done by a scale ranging from 1-5, where 1 is a favorable position and 5 is unfavorable. Furthermore the quantification has been divided into 3 categories; the past, the short-run and the long-run. This has been done in order to make the model less static and ease up the development of forecast drivers. The turbulence of the environment in which BMW operates quantified at a level of 3 in the degree of turbulence analysis. This means that the market is changing but it is possible to forecast most changes. This can, however be a problem when using Porter’s 5 Forces Model, since it is criticized for being very static. Due to its static nature it is not capable of depicting the changes in the market structure. Still the model was chosen, because it is common tool for describing the competitive environment of company. 4.3.1 Industry Rivalry The industry rivalry will be evaluated by looking at some key areas. Marketing and Branding The industry of premium cars is characterized by fierce competition. The name of the game is branding. No other industry is so focused on the usage of catchphrases. Take for instance BMW, Page 37 of 93 that uses the following catchphrase: The Ultimate Driving Machine (www.bmwgroup.com, 2010). The branding and brand awareness is something the car manufacturers are investing heavily in. Examples of BMW’s engagement in sponsorships are: Sport events and events with the focus on sustainability. BMW’s does obviously make sure that the events they sponsor are in line with the image, which BMW has. BMW e.g. sponsors golf tournaments (Golf Today, 2010), America’s Cup sailing (www.bmworacleracing.com, 2010) and Olympia 2012 in London (www.auto-motor-und- sport.de, 2010). Leasing Financing In recent years, there has been a significant increase in the financing activities of BMW and their competitors. All larger car manufacturers in the world have financing as a separate business unit, performing leasing services, financing and even banking to their customers (Datamonitor, 2009a,b,c,). This suggests that the companies are trying to boost their sales by offering their customers ways of financing their purchase. This has opened up all new market opportunities for branding, marketing and it has increased competition. This is substantiated by the increase in demand for leased products (www.automotivenews.com, 2010a). Static Industry There has been very little change in the world top 10 largest manufacturers of cars in the period 2003-2008, the two recent years, however, have seen 1 new company in top 10 each year (OICA, 2010). This fact, in combination with several mergers starting in the late 1990’s (Automotive news, 2003), suggests that this is a well-consolidated market. It seems to be obvious that competition is working fine and companies are investing in large production facilities in order to achieve economies of scale. The ten biggest companies have been successful in this endeavor, since there are no other indicators pointing in the direction of less competition. The concentration ratio among the top four producers is at 41.62% (OICA, 2010) with an even distribution among the four, which does not indicate any problems with the competition. Financial Crisis and M&A The financial crisis, which hit the world with all its fury in the second half of 2008, has brought several of the major car manufacturers to their knees. This seems to be especially true for the American manufacturers: GM, Chrysler and Ford, which received state funded financial support in order to stay in business (Ingeniøren, 2008). This could mean that the future would hold even more Page 38 of 93 mergers and acquisitions, because some companies might find cheap struggling companies that could fit into their portfolio. The industry rivalry is considered to be very fierce in the premium automobile segment. This is seen on the basis of the high marketing and branding efforts that the companies engage in. Furthermore the rivalry is expected to increase even further in the future. This is based on the possibility of new entrants to the market. 4.3.2 Entry Barriers The premium car manufacturing industry is characterized by heavy marketing expenditures allowing the companies to charge a premium for their products. The products in this segment are considered to be more luxurious and of better quality than the competitors in the more ordinary classes, such as Toyota, Ford, Nissan, Suzuki and Mazda. Heavy marketing expenditures, as well as inputs of higher quality, ensure the companies in the premium car segment, their mark-up. Customers are willing to pay a price premium for the image of premium brands. They want to make a statement with their purchase of a premium car and it is this statement that the heavy marketing expenditures ensure. Potential entrants to this segment will have to spend a lot of money on branding their products in such a way that the consumers see their products as being of equal quality and technological standard. R&D Investments Investing in marketing is not everything. In order to secure a foothold in the premium segment the intruding company must also focus on continued development of the cars. Design, production and quality-management are just a few areas. BMW has an advantage in terms of R&D investments, because they have a base to build on and do not have to start from scratch, like new entrants to the market, would usually have to. Emerging Countries There is a growing export potential in the developing economies, with China in the lead. This export potential can lead to a significant threat to BMW if a Chinese competitor enters into the premium segment market, with a product as good as BMW’s. These emerging countries are characterized by low cost production and they are constantly increasing their scale (Peridy & Abedini, 2008, p. 1). In 2006, China was the third largest car manufacturing country; in 2008 they came in second just after Japan (OICA, 2010). This can be a threat to BMW, because BMW does not have the same home market to gain an equal economies of scale as Chinese producers. Page 39 of 93 Distribution Network Today, BMW has a large extensive network of distributors. BMW is present in more than 150 countries worldwide and distributes its products either through company owned showrooms, independent dealers, subsidiaries or importers (Datamonitor, 2009b, p. 5). This is a very extensive and large network but it is needed in order to secure BMW’s quality requirements. A potential entrant must acquire or build a distribution network. This can be a very expensive and difficult investment but necessary if the company wants to control the vital service level, which is the basis for creating a loyal customer base. 4.3.3 Bargaining power of buyers When thinking about the potential buyers in a Porter’s 5 forces model, backward integration and switching costs come to mind. Backward integration meaning the possibility that costumers of the car industry are starting to produce their own cars is considered very small. The Switching costs of the general car industry is however very low. It means that it is very easy for the costumers to switch to another car brand if they are not happy with their current one. This gives customers bargaining power over the car manufacturers. For the premium automobile market the situation is a bit different. Customers in this segment have a reason for spending more than necessary for a car. Customer do often have high expectations when they buy a premium cars. This increases the need for the companies of the premium segment to deliver a service and a product, which is a bit out of the ordinary. If the customers are not happy they will either not come back the next time they are purchasing a new car or they will cause the company a lot of trouble. Both scenarios are costly for premium producer and both scenarios damage the company’s image. These factors clearly give the buyers bargaining power over the company. This fact has also increased the awareness in BMW of maintaining a good relationship with the buyers and the company has developed a customer relationship management program (CRM) (www.allbusiness.com, 2010). The implementation of CRM and BMW distinctive brand contributes to customers being more loyal and it therefore decreases the bargaining power of the buyer. Leasing and Costumer Relationships Leasing of new cars has become a more and more important part of financing new cars. For BMW this is also true. Leasing agreements generated roughly 10% of their revenues in 2008 (BMW AR, 2008). Leasing can help the company to maintain a good relationship with buyers, since they are receiving payments from them each month and hence stay in continuous contact. Furthermore the Page 40 of 93 customers have to return the car at the end of the leasing agreement, which creates an ideal opportunity to inquire the customer about the car and gives the possibility of setting up a new agreement. This suggests that the bargaining power of buyers is of less importance. All in all, customers bargaining power is assessed to be of minor importance for BMW. 4.3.4 Substitute Products The threat from substitute products comes from the fact that they are able to perform the basic task of the car e.g. transportation from point A to B. This could include alternatives such as trains, busses, bicycles or even walking. However in the case of BMW substituting products as the above mentioned might not be relevant to examine, since a BMW is meant to be much more than just a mean of transportation (www.bmwgroup.com, 2010). A buyer, who considers whether to buy a car or simply just commute by means of public transport would not buy a BMW, since such a buyer might be looking for the cheapest alternative and that is not BMW. The threat of such substitute products is therefore considered to be very low. Other car manufacturers Instead of looking at the alternative means of transpor