The Economics of Desire
Pramit Ghose
Global Strategist

I recently attended Mercedes Benz’s investor conference, cleverly called the ‘Economics of Desire’, with management presenting to fund managers and analysts the company’s ambitions to ‘move up’ the luxury segment and improve longer-term margins.

‘The desire to own something special is timeless’ commented CEO Ola Kaellenius, with the screen behind him showing an image of a 6,000-year-old jade axehead in the British Museum, a Neolithic luxury status symbol.

The company has, since COVID struck in early 2020, been pursuing a strategy of improving price and product mix to maximise margins and profitability despite reduced volumes due to the global supply chain issues hampering car production (as any of you trying to buy a new car can validate).

The company’s medium-term goal is to continue this strategy, targeting margins of 14% (it was 6% a couple of years ago), reducing volumes and models at the ‘Entry Level’ segment, and leveraging its brand strength to offer more cars at the (more profitable) top end.

Mercedes Benz is one of only four brands to have ranked in the top 12 of Interbrand’s most valuable global brands in every year for the last 20 years. The others are Coca-Cola, Microsoft and Toyota. Yet, based on Interbrand’s assessment of its value, the Mercedes-Benz brand is seemingly the most underappreciated in its share price.

Mercedes Benz’s leading S-Class (luxury saloon) and SL-Class (luxury coupe) models, along with the more exclusive Maybach, G-wagen and AMG brands, means that the company sells some 200,000 cars priced at over €90k, giving it a c.35% market share in the global ‘luxury’ segment of some 650,000 cars selling above €90k.

It’s a credible plan, given the company’s brand and ability to sell relatively high volumes at high price points, although their expected margins, while excellent versus the past, are significantly below those achieved by Ferrari or luxury goods giant LVMH.

The company is also rapidly developing new electric models; the new EQS (S-Class full electric model) has had strong reviews and sales, and there is a strong line up of new fully electric models coming over the next 12 months, with c.600km ranges, including an S-Class SUV and EQE (fully electric E-Class, which I was able to test drive, an amazing car, watch out Tesla!).

However, management’s confidence in its strategy and profitability targets is clearly not reciprocated by investors. The shares trade at a miserly 5.5x 2023 forecast earnings, 3.5x cashflow, and an almost 8% dividend yield (source: Bloomberg). That means, in theory, one could buy a company with such heritage, brand, market share, engineering prowess, marketing skills and technology ability for just 5.5 years of (after tax) profits. And these figures include the significant costs of developing and launching the new EV models.

For comparison, Ferrari trades at 30x 2023 earnings, while luxury goods giant LVMH trades at 19x earnings. As for its ‘main American competitor’, Tesla shares trade at over 45x 2023 earnings despite being down some 30% this year.

Meanwhile, on an equivalent valuation scale, the German 10-year bond trades at 100x ‘earnings’ (1% yield).

When we analyse companies for investment, we assess both the upside potential and the downside risks. It seems to us that given Mercedes’ strong brand and ability to raise profits and margins through the COVID crisis, downside risk at these low valuations, barring a full-blown recession (which we don’t think likely), is limited. On the other hand, if management continues to deliver, and investors start to re-rate the company, there is good upside; even a modest 7.5 – 8 times price earnings ratio valuation would give c.40% returns at the current share price.

Buyers of Mercedes Benz cars value their quality, reputation, engineering and brand, and are willing to pay premium prices. Buyers of Mercedes Benz shares do not. It’s a huge divergence. And that’s where the investment opportunity is.

 

Disclosure: The author’s pension scheme owns shares in Mercedes Benz Group.

Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.

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