What Mercedes Is Doing To Close-In On BMW Before This Decade Ends

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DAI
DAIMLER AG

This time ten years ago, Mercedes-Benz was the highest-selling luxury automaker in the world. But the vehicle brand owned by Daimler AG lost its lead to compatriot BMW in 2005, and further fell below Audi in 2011, to consolidate its position as the third largest premium automaker. In order to regain its lead, Mercedes laid-out its product offensive strategy aimed at launching various new models, investing higher in geographical expansion, and developing models of the future. This strategy seems to be paying off for Mercedes volume-wise, as on the back of new model launches such as the compact CLA-Class, and model makeovers given to the sedans E-Class and S-Class, the brand’s volumes rose 11% year-over-year in 2013, more than the 8.3% and 7.5% growths seen at Audi and BMW respectively. Mercedes has further narrowed its gap with BMW this year, selling 12.5% more vehicles through the first three quarters, more than the 8.5% rise in volumes for BMW during this period.

Mercedes is no doubt closing-in on BMW through new model launches and extension of its production footprint. However, the product offensive strategy has also taken a toll on the company’s financials. One-time costs associated with the launch of new/refreshed models had lowered operating margins to around 3% a couple of years ago, but a favorable product mix and efficiency initiatives such as the ‘Fit for Leadership’ program has helped Mercedes sequentially improve its profitability. Operating margins for the German company stood at 7.8% through September, with the figure improving to 8.5% in Q3. However, the operating performance at Mercedes still lags that of BMW, which reported margins of 10.2% through the first three quarters. The struggle to become the largest premium automaker has chipped away at Mercedes’ profits in recent times.

Over the last 18 months, increases in both volumes and operating profits have been positive for Mercedes, which is now bang in the middle of its product offensive strategy, and aims to topple BMW by the end of this decade. Among various markets and market trends that impact Mercedes’ contention for the global luxury vehicle throne, we single out the Chinese automotive industry and the growing demand for compact premium vehicles.

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Why Is China Pivotal For Mercedes?

China is not only the world’s largest automotive market by a distance, it is also the fastest growing premium vehicle market. Only second to the U.S., China’s luxury vehicle market is expected to grow at around 13-13.5% this year, more than the expected 8.3% growth for the country’s overall vehicle market. This is because the penetration of luxury vehicles still remains relatively low in China, and with increasing disposable incomes, sales of these vehicles is anticipated to rise. Compared to around 10-11% contribution of premium vehicles to the overall vehicle volumes in the U.S., the figure for China stands at around 7%, according to our estimates. In fact, China is expected to surpass the U.S. as the world’s largest luxury automotive market in a couple of years, and cross 3 million in sales volumes by 2020, up from an estimated 1.52 million unit sales in 2014. But why is China so important for Mercedes?

After the US, China is the second largest market for Mercedes, forming almost one-fifth of the net volumes so far this year. The automaker’s volumes in the country have increased 26% year-over-year through October, outpacing the growth seen by the brand in any other country. China’s growth is important for Mercedes to close-in on BMW, even more so as the latter sells more vehicles than Mercedes in the country. BMW sold 6.5% more vehicles than Mercedes through the first three quarters worldwide, i.e. 80,290 units. If we exclude China sales, Mercedes volume sales exceed that of BMW’s by over 40,000 units. Audi and BMW are the runaway leaders in China, and Mercedes now looks to strengthen its sales in this region by focusing on compact models, local production, and increased availability.

Mercedes To Expand Production Of Compact Models

In November last year, Daimler had acquired a 12% stake in the Chinese BAIC Motor, the passenger car division of its China partner the Beijing Automotive Group, to further its business in the Chinese automotive industry. The joint venture’s manufacturing plant at Beijing already produces the C-, E-, and GLK-Class models, and will now start producing the compact crossover GLA-Class by early next year. [1] In addition, Daimler recently announced plans to extend partnership with BAIC Motor, investing around $1.27 billion for the localization of additional compact sedans other than the GLA in China. Both the companies will jointly invest around $5 billion through 2015 to increase automotive production in China. [2] This means that by next year, Mercedes will start selling locally assembled compact entry-level premium models in the country.

This new development bodes well for Mercedes, as not only will the German automaker benefit from evading the 25% import taxes, consumption and value-added taxes in the country on account of local production, but the large demand for entry-level vehicles could significantly boost China volumes for Mercedes. IHS automotive expects compacts to constitute 20% of all luxury vehicle sales next year in China, as customers flush with cash look to trade-in their large non-luxury sedans for entry-level premium vehicles. Compact models like the C-Class and 3-series are volumes models for Mercedes and BMW respectively, and with the launch of the technically upgraded C-Class in late August in China, Mercedes could inch closer to BMW in terms of China volumes.

October volumes for Mercedes rose by 33.4% over 2013 levels, bolstered by the high demand for the newly revamped C-Class, and with the launches of the locally-made GLA-Class next year, volumes for the company could rise further. Compact entry-level vehicles are volume models for automakers, and Mercedes’ focus on expanding local production of its compact series will enable the German brand to compete better on a pricing front and increase its unit sales significantly. Local production of Mercedes’ lower-end relatively affordable luxury vehicles in China will also be supported by a simultaneous rise in dealership points, consequently improving reach and availability. Daimler plans to open around 100 new dealerships in the country this year, after opening around 75 in 2013. These new dealerships are mostly in Tier 3, 4, and 5 cities, in order to cater to the potential consumer base seated deep into the country, where incomes are steadily rising. Over 50% of additional growth in the number of mainstream households in China will be contributed by lower-tier cities, according to McKinsey. Mainstream households consist of potential luxury item buyers, which are most likely to purchase lower-ranged premium vehicles.

China volumes have increased for Mercedes in the recent past on new model launches and higher proportion of locally produced vehicles. Mercedes manufactures over half of its China volumes in the country itself as of now, and as the German automaker further expands its production base in the country, especially of highly popular compact models, it could narrow its gap with BWM in the coming years.

Margins Might Not Reach 10% In The Near Term

By accelerating growth in China, Mercedes might close-in on BMW for the global luxury lead, but margins for the former are expected to remain below the elusive 10% mark in the near term. Mercedes opened its new research and development center in Beijing this month, investing around $17 million in this site alone, and a cumulative $140 million in China so far on research and development facilities for Mercedes-Benz passenger cars in the country. [3] Daimler spent over $930 million in Q3 on R&D for Mercedes-Benz (5% of divisional revenue), and expects capital expenditure for the entire group to rise to $6.2 billion this year. According to our estimates, capital expenses and R&D costs could form around 11.5% of the net revenues for the luxury vehicle division in 2014.

A favorable product mix could drive margin growth for Mercedes in the coming quarters, but as the company continues to aggressively invest in production expansion and newer technologies, higher costs are expected to keep the brand’s operating margins below the 10% mark. Operating margins reached 8.5% this quarter on the back of higher proportionate sales for the relatively more expensive S-Class sedan, which carries fatter margins, sales of which almost tripled this quarter to 28,200 units. The company also launched the S-Class Coupé and the S 500 plug-in hybrid at the end of September in Europe, and stronger sales of these models could push Mercedes’ average revenue per unit, and consequently margins, higher in the last quarter.

Although high investments in manufacturing facilities and R&D are expected to weigh on the company’s profitability in the near team, a favorable product mix and benefits from local production could boost margin growth. For example, the new model year of the C-Class is the first Mercedes-Benz model to be produced in four continents, reflecting the high demand for compact luxury vehicles worldwide, and also the company’s commitment to draw cost-benefits from local production. The model is being manufactured in Germany, South Africa, the U.S. and China. High demand for the smaller-sized premium sedan has resulted in production facilities running at almost full capacities, and as automotive companies have high fixed costs, increased volume sales would enable Mercedes to earn higher profits on each incremental sale.

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Notes:
  1. Daimler press release []
  2. Daimler press release []
  3. Daimler press release []