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Continental Keeps Investors Pleased with Strong Returns

  • Why it matters

    Why it matters

    Continental, the world’s largest auto parts supplier and a manufacturer of high-quality tires, has its annual general meeting this Friday.

  • Facts

    Facts

    • Continental’s auto parts division is responsible for producing some of the most important technical components for self-driving cars.
    • That’s why the company has increased the unit’s R&D budget by 9.9 percent in 2016.
    • Shareholders are expected to sign off on a dividend for 2016 of €4.25 per share, an increase of €0.50 over the year before.
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    Audio

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Continental
Strong tire sales have allowed Continental to focus on carving out a niche for itself in the self-driving car market. Source: dpa

As he gears up for an annual general meeting on Friday, the chief executive of the world’s biggest supplier of car parts knows investors are hoping he will take on a more Solomonic role.

They want Elmar Degenhart, CEO of Continental, to split the company in two. They’re titillated by the prospect of capitalizing more on the fact that Continental is already developing the most important technology for the self-driving cars of the future.

Many shareholders think breaking that division off from the company’s tire-making unit would significantly increase the brand’s stock market value from its current €40 billion ($43.6 billion).

Mr. Degenhart, however, thinks it would be wiser to leave his organization intact. Either way, there’s little chance of an investor revolt this Friday, when the CEO will present the results of the last year’s business and his visions for the future.

Dividends have continued to flow even as Mr. Degenhart has kept both units under one roof.

Part of the reason the danger is so mitigated is because nearly half of shares in Continental are held by the family-owned auto parts maker Schaeffler, whose board members, like Mr. Degenhart, don’t think the sum of two Continentals would necessarily be greater than the whole.

Beyond mere managerial unanimity, however, there are other reasons for Continental to maintain the status quo. Whenever the company’s parts supply business gets into trouble, revenues from tire sales are always there to pick up the slack. Plus, the tire division provides the necessary liquidity for Continental to evolve the networked driving systems it sells.

On Friday, Mr. Degenhart will be able to report on a vastly successful 2016 for the company – with a few caveats. Sales may have increased by 3.4 percent, but Continental’s earnings faltered slightly. Earnings before interest and taxes fell, and the EBIT margin declined to 10.1 percent, from 10.5 percent the year before. The group’s capital returns were also down.

Nevertheless, there’s no real reason for shareholders to demand a fundamentally different corporate strategy from Continental’s board. Dividends have continued to flow even as Mr. Degenhart has kept both units under one roof. On Friday, investors are expected to greenlight a dividend for 2016 of €4.25 per share, €0.50 more than the year before. This will be the company’s fifth consecutive dividend increase, putting its dividend yield at 2.3 percent – the median value for companies listed on Germany’s blue-chip DAX stock index.

A higher dividend is possible for two reasons. For one, Continental has managed to pay down its massive debt pile. That debt came from its takeover of automotive electronics firm VDO from Siemens back in 2007, as well as the general weight of the global financial crisis.

Continental has become much more flexible since it began to reduce its debt burden, a move spearheaded by CFO Wolfgang Schäfer in 2016. Since he began, the company’s net financial debt fell from €3.5 billion to around €2.8 billion. Lower interest payments have also enabled the group to achieve a slight increase in net profit of nearly €100 million.

Secondly, Continental’s decline in operating profits is mainly due to one-off effects, which won’t likely be repeated in the coming fiscal year. The company had to raise some €500 million to cover warranty payments and possible cartel fines in a European anti-trust case. EU investigators suspect that Continental and another German company, Bosch, fixed the price of electronic brake and steering systems.

Continental is putting heavier emphasis on high-quality tires, seeking to assert itself in the top-end market.

One look at Continental’s books reveals the imbalance between the company’s tires and parts units. The tire sector, otherwise known as the Rubber Group, was responsible for 40 percent of turnover, while 60 percent came from the Automotive Group. But when it came to returns, the inverse was true: tires contributed around €2.7 billion to the group’s EBIT, while the Automotive Group generated €1.5 billion.

Continental’s board members can be grateful they never decided to stop producing tires. Today, that’s where the company earns the money it needs to cover planned investments in digitization and electric powertrains. On Tuesday, the Hanover-based company said it was earmarking an additional €300 million to be invested in new technologies by 2021.

The tire unit’s return on sales has logged considerable successes lately. Last year, it climbed to 16.7 percent – a number most manufacturers in the automobile sector can only dream of. With such high returns, Continental is almost at the same level as Porsche, the renowned German maker of sports cars. Porsche’s sales returns grew by 17.4 percent last year. Michelin, the French tire maker and a direct competitor of Continental’s Rubber Group, achieved a 10.7 percent increase in returns on its sales.

Continental is profiting from a very long-term strategy for its tire unit. First and foremost, the company has been paying a great deal of attention to its own costs. Production only takes place in factories with favorable, i.e. inexpensive, wage deals with workers and very low overall operating costs. The company only maintains two plants in Germany, where workers enjoy strong protections and labor costs are high.

In addition, Continental is putting heavier emphasis on high-quality tires, seeking to assert itself in the top-end market. This also means that Continental is trying to concentrate on tires with larger diameters, which are harder to produce because they demand a certain know-how. Chinese tire manufacturers have had trouble keeping up, since they lack the technical knowledge to guarantee quality for larger tires. According to Jose Asumendi, an analyst at JP Morgan, Continental leads the pack when it comes to making tires. The company is simply the “best in class,” he said.

“We won't be running out of ideas anytime soon.”

Elmar Degenhart, Continental CEO

It seems that when it comes to tires, size does in fact matter. With SUV sales on the rise, there is a higher demand for bigger tires. Once a company is producing SUV tires, the leap to even larger semi-truck tires isn’t all that big.

At the moment, Continental’s tire business seems to be running on autopilot. The company has invested the equivalent of 2.4 percent of sales in research and development in this sector.

The good results from the tire unit also ensure that Continental always has enough money in the bank. At the end of 2016, the company had a liquidity cushion of around €6 billion, of which €2.1 billion was in cash and cash equivalents and €3.9 billion was in committed, unused credit lines. Compared to the end of 2015, that liquidity had increased by €762 million. Free cash flow had risen by just under 23 percent last year to €1.77 billion.

The Automotive Group, on the other hand, isn’t doing quite as well. The EBIT margin fell from 8.5 percent to 6.2 percent, which was mainly to do with special charges. The chassis and safety division had to set aside €390 million for warranty payments from 2004 to 2010, as well as for the cartel penalty. The unit’s other two divisions are for powertrains and interiors.

Even without those additional burdens, the company would still have made far fewer returns supplying parts than selling tires. That’s because the Automotive Group’s R&D bill is considerably higher than that of the Rubber Group. Those costs have risen by 9.9 percent on-the-year.

In recent years, the importance of new-age driving systems has increased exponentially. This has included software that connects automobiles to the Internet, algorithms that allow cars to drive themselves and new powertrains such as electric engines or alternative fuel cells.

Sales of some of these revolutionary innovations amounted to €1.2 billion last year. “For the year 2020, we’re already expecting sales of well over €2 billion,” Mr. Degenhart has said. Naturally, ambitious sales targets like this translate into high research budgets.

Shareholder equity rose by 11.4 percent in 2016 to €14.7 billion, the highest it’s ever been in the company’s history. Continental has thus gained a new scope for further acquisitions. Mr. Degenhart has said a buyback of shares is off the table, if for no other reason than to do investors a favor. In Hanover this Friday, Continental’s operation business will be in the foreground.

“We won’t be running out of ideas anytime soon,” the CEO said.

 

Stefan Menzel writes about the auto industry for Handelsblatt. Bert-Friedrich Fröndhoff leads a team of reporters which covers the chemicals, health care and services industries. To contact the authors: menzel@handelsblatt.com, froendhoff@handelsblatt.com

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