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Green Machine
By VITO J. RACANELLI

CRUISING ALONG A BUSY MUNICH street in a BMW 118d last summer, I was treated to the sharp handling and snappy styling that typifies even the 1-Series, the lowest rung in the company's expanding model range. Turns were crisp and even the small engine -- just 143 horsepower -- had pep.

What affected me the most, however, wasn't expected: the automatic stop/start function, a fuel-efficiency technology that turns off the engine when the car halts at, say, a red light and then starts it again as the clutch is depressed. I expected the shut-down, but the quiet that followed was jarring. Many American drivers probably will be similarly surprised in coming years by a suite of new technologies dubbed "Efficient Dynamics" that the Munich-based manufacturer is introducing into its cars. Investors, meanwhile, may be happily surprised by BMW's heightened interest in pleasing its shareholders.

In early October, the auto maker will give a much anticipated corporate review, at which it will present its long-term strategy. Among the topics will be its research-and-development and capital-expenditure plans. Barron's has learned that BMW will for the first time reveal a target for return on capital employed, or ROCE, in its core auto operations (the company makes motorcycles, too). This measure's decline from 30% in 2002 to 21.7% last year has worried many investors and hurt BMW stock, which would certainly benefit if the German giant sets -- and more important -- hits a robust ROCE target.

A factor that may help make that a reality: BMW, whose engineering DNA is directed toward making "ultimate driving machines," is going green.

Among German luxury-car producers, BMW is arguably the leader in clean-engine technology. This has come at a price, however, as high R&D costs, among other things, have hurt profit margins, even as BMW has become the globe's leading premium-auto maker by unit sales. Part of that R&D is for green technology, but plenty was plowed into updating its product portfolio. The big Bavarian concern will have revamped or introduced some 14 models by the end of this year, including the Mini, the 1-Series, the X5 SUV and the 3-Series, the last two representing nearly 50% of its unit sales.

BMW'S SHARES LATELY HAVE been shunned by many institutional investors. But bullish investors argue that the stock will rise 20% or more if second-half 2007 margins expand on easing costs and easy comparisons to 2006. (More on that below.)

Efficiency is hardly a new concept at BMW. But growing fears about CO2 emissions are pushing the car industry to produce models that generate less greenhouse gas. Reducing carbon-dioxide output is a particularly daunting engineering challenge for luxury-car makers like BMW (ticker: BMW.Germany), Mercedes, which is a unit of Daimler (DAI.Germany), Porsche (POR3.Germany) and Audi, owned by Volkswagen. They sell many fewer cars than the mass producers, but their models are lightning rods for critics, particularly in Europe. Since luxury vehicles tend to be the heaviest, most powerful and thirstiest, they typically emit more CO2 per kilometer traveled.

"It's inevitable that luxury cars will have to get cleaner," says David Friedman, research director for the vehicles program at the Union of Concerned Scientists, but "...BMW is clearly making some investments in this direction." He points in particular to its aim of putting greener technology into engines across its model lines.

Doing this may be a matter of corporate survival. The worries over the rise in the Earth's average temperature threaten to lead governments to impose increasingly stringent and costly emission curbs, plus higher taxes on cars that pollute more.

In February, the European Union announced that it would propose rules in 2008 to force manufacturers to limit emissions for new cars to an average of 130 grams of carbon dioxide per kilometer by 2012. Luxury cars now typically emit roughly double that. Even stricter European targets are contemplated for 2020. In comparison, recent California legislation mandates roughly 190 g/km (adjusted for differences between U.S. and European test methods) by 2012, notes Friedman. Many European countries, including France, the U.K. and Norway, already have a CO2 emissions-registration tax, which disproportionately bashes bigger polluters.

"It's a balancing act, energy usage versus driving pleasure, but we Germans are very green right now, and car makers here are being heavily criticized," observes Thomas Meier, a portfolio manager at LOYS, an institutional investor in Oldenburg, Germany. The just-ended Frankfurt Auto Show -- arguably the auto industry's most important event -- was marked by numerous exhibitors placing low-emission models front row center, while pushing their high-performance cars to the rear. "It was like a gardening show," jokes BMW's chief financial officer, Stefan Krause.

The trick for BMW -- and all luxury-car producers -- is to reduce consumption and emissions without sacrificing the qualities that customers expect of their cars.

"It's a holistic approach," notes Hans Rathgeber, an engineer spearheading BMW's efforts to make its vehicles more efficient. "We look at every point in the car where we lose energy and try to reduce it." The stop/start function is just one prong of "Efficient Dynamics," he notes. Among the things that BMW has introduced or soon will: electric-powered steering to replace conventional hydraulic systems; a water pump that works only when needed, rather than continuously; brake-energy regeneration; leaner-burning fuel combustion, and a lightweight magnesium-aluminum engine.

Starting with the 2008 model year, 22 models -- accounting for 40% of the BMW Group's European sales -- will be producing no more than 140 grams of CO2 per kilometer, he says. This includes not only the Mini line of small cars, but also 1-, 3- and even some 5-Series models. Even the company's high-end 7-Series is getting greener, as BMW is building and testing 100 of the cars with engines capable of running on gasoline or liquid hydrogen. Using the latter, the emissions are mostly water vapor.

Fuel efficiency hasn't been a core demand of the German premium car makers' customers, notes Christoph Stuermer, a London-based auto analyst for Global Insight, a research and forecasting consultant. "But the awareness is changing.... BMW leads in making their cars more fuel-efficient on a wide basis, that is, across its entire fleet," he says. In comparison, he adds, Mercedes' most touted advance -- Bluetec technology -- is only for diesels.

BMW also has been more successful than its key competitors in implementing one of the better strategies for reducing a fleet's average emissions -- selling small cars. It introduced the Mini in 2001, having acquired it during a disastrous stretch in which it bought Britain's Rover, lost billions trying to fix it, and then happily unloaded it. The Mini has become a mega-phenomenon; more than a million have been sold in the past six years. Meanwhile, Mercedes' little SmartCar, which it intends to soon bring to the U.S., has produced billions of dollars in charges to earnings.

SO FAR, BMW'S GREEN-TECHNOLOGY prowess hasn't done much for its stock. Since June 2005, the Frankfurt-traded shares, which closed Friday at 43.57 euros, have returned just 27%, versus about 85% for the European auto industry group and 99% for DaimlerChrysler -- soon to become just Daimler -- which owns Mercedes, as well as huge truck-making operations.

Ironically, BMW's stock has weakened since the company took the mantle of world's top premium-car maker from Mercedes in late 2004. This year, BMW expects "high single-digit" percent unit sales growth, to "significantly more than 1.4 million vehicles." Last year, it sold 1.37 million. Through August, BMW's global sales (including those of the Mini and Rolls-Royce) were up 7%, while Mercedes' were off slightly. The smaller Audi's sales were up 9%.
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BMW's challenge is clear, notes Henning Gebhardt, head of German equities at Deutsche Asset Management in Frankfurt: "Volumes have been fine, but at the end of the day, there's not been a lot of additional profit." While aggregate profit generally has risen steadily over the past seven years, pretax auto margins -- a key metric for most analysts and investors -- fell to 6.3% last year from more than 8% in 2001. It slid to 5.3% in the first quarter, before recovering to 5.5% in the second.

Rivals are doing better. Though unit sales fell 3%, the Mercedes Car Group's earnings before interest and taxes jumped to nearly ?2 billion in the first half from a slight loss in the corresponding 2006 stretch. Daimler's premium-car unit sports margins around 7%, aided by lower costs and a decline in the quality problems that dogged it for a time, bloating warranty costs. The company is now aiming for 10% margins. Audi's profits in the first half jumped 67%, to ?679 million.

Highflying Daimler also wins points from investors for selling over 80% of Chrysler recently and for having a CEO, Dieter Zetsche, who is considered shareholder-friendly. Besides the Chrysler move, he's promised to buy back up to ?7.5 billion worth of shares -- something not common in Corporate Germany.

In contrast, BMW is seen as more conservative and aloof, less pressured to make shareholder-friendly moves because of the 47% stake owned by the Quandt family. Consequently, BMW, whose raison d'?tre is engineering, has less of a restraint on a tendency to "invest for investing sake," says John Botham, head of European equities at Morley Fund Management.

BMW's first-half net dropped 23%, to ?1.34 billion, even as unit sales rose 5%. The company blamed higher material costs as well as the dollar's slide; BMW gets about 25% of its sales from North America. The greenback's decline hurt earnings in 2006, for example, to the tune of ?666 million. Last year, the company earned ?2.87 billion on nearly ?49 billion in revenue.

The biggest beef that investors have with the Bavarian car manufacturer is its relatively high spending on research and development and on capital expenditures. According to Credit Suisse analyst Arndt Ellinghorst, BMW spends far more than its rivals on R&D, capex and labor per car. (See table below.) If it spent at a level equal to Mercedes, he adds, BMW could get its pretax auto margin back to over 8% and reduce annual cash outlays by about ?2 billion.

Morley's Botham, who owns shares of Daimler but not of BMW, says he'd be more interested if BMW indicated that it is serious about cutting costs. Several other institutional investors tell Barron's much the same.

One thing that BMW does have going for it is valuation. At its recent price of ?43.57, it was trading at over 10 times the 2007 consensus EPS estimates of ?4.08, a big discount to its peer group, which trades at 14.1 times. Take out BMW's ?6.5 billion, or ?10 a share, in cash and the price-to-earnings multiple is even lower, notes Daniel Kerbach, a portfolio manager at LGT Capital Management, which owns both BMW and Daimler. And while BMW has been investing heavily, it now has many more improved models available as a result. "It will take a few quarters, but that will pay off," Kerbach adds.


BMW's new-model cycle is peaking this year, and sales should benefit in 2008 and 2009. "They've renewed their model range quite rapidly and haven't had all the revenue yet from all the renewed models," says Kristof De Graeve, an analyst at SG Private Banking in Ghent, Belgium, who's bullish on the company. BMW's margin of 5.5% in the second quarter was "much too low.... BMW is a bargain because margins could go up significantly," he avers.

JUST ABOUT ANY IMPROVEMENT could bolster the stock because few expect to see a gain. "There are very low, if not zero, expectations for BMW," says Merrill Lynch analyst Harald Hendrikse, who notes that the stock is trading at one of the lowest valuations in its history. The Munich-based manufacturer is getting no credit for having generally steady earnings growth since 1999, while both VW, Audi's parent, and DaimlerChrysler have had a rollercoaster profit history since then.

Hendrikse, who has a Buy rating on BMW, expects a sharp acceleration in second-half 2007 earnings and margins, stemming from continued good sales growth and relatively easy comparisons with results in 2006's last six months. Additionally, some R&D and capex costs were "front-end"-loaded in 2007, and will be less of a drag on margins in the last half, he observes. The stock, he contends, could reach the mid-50s if results turn out to be good. And it could go into the 60s, Hendrikse says, if BMW says the right things at its coming strategic review.

Investors are anxiously awaiting this presentation from Norbert Reithofer, who took the CEO reins about 12 months ago and is expected to lay down a strategy for BMW's long-term future. The market will be keenly attuned to anything that would suggest BMW aims to get margins up.

In that strategic review, "I'd like to see them bring down R&D," says Naimish Shah, an analyst with Lord Abbett, which owns a BMW stake. Cutting that significantly in the short term might be difficult, but "just the mere acknowledgment that their costs are higher than peers' would be a positive" for the stock, he argues. He'd also like BMW to talk about cutting capital outlays a bit and discuss any joint ventures or alliances it plans, to spread costs across a wider base of cars. Even a small decline in capex would significantly aid earnings, he says.

BMW CFO Krause is familiar with investors' concerns. To gain an edge for the long term, he says, "we had to invest" in things like Efficient Dynamics, but that "burdened R&D costs....but we know that's one area we can improve. Our capex needs to go down." He won't give specific numbers, but adds that the company has ample ammunition on the cost side: "We have leverage in the 'capital employed' part" of the return-on-capital-employed equation. As for the possibility of new alliances, he says: "We continuously explore with other manufacturers areas where we can cooperate. When it makes sense we will engage in it."

Shah says that BMW should also take advantage of its "flush balance sheet" to better the stock's payout ratio. He's "highly confident" that BMW -- whose estimated 2007 16% payout ratio (dividends and share buybacks) is lower than the 25% industry average -- will address this issue. After all, he continues, the Quandt family must be frustrated at the stalled share price, given the sales rise in recent years.

Only CEO Reithofer, who declined to speak with Barron's, knows what he'll say at the strategic meeting. But the company's top brass realizes that if margins stay where they are, the Quandts eventually will question management's strategy. In the past, they've shown no reluctance to make changes at the top.

Going green is probably a wise move for BMW, and good sales growth will push the shares higher in the near term. But to rev up the stock longer term, BMW must give shareholders more of what they want.