Automotive Operating Margin in 2018: Change is Coming

Volkswagen AG recently announced that it would be shedding up to 7,000 jobs at their core VW brand in a bid to boost profitability and prepare for the electric revolution. VW expects it to deliver €5.9 billion in annual savings and has targeted an operating margin of 6%, relative to its 2018 performance of 3.8%.

To an outsider 6% appears to be an arbitrary number and why is it such an important metric of financial performance? And what does it all mean for the industry?

So, what is operating margin?

For those who don’t know, EBIT stands for Earnings Before Interest and Taxes which is calculated as Revenue – Expenses.

Operating margin is calculated as EBIT/Revenue x 100.

Revenue is also sometimes referred to as Sales Revenue and is often seen as interchangeable with Sales.

Expenses include COGS, ‘Selling, general and administrative expenses’ and ‘R&D expenses’. Sometimes there are also ‘Other expenses’ too, to consolidate any other items.

COGS? Cost Of Goods Sold, sometimes also referred to Cost of Sales. Cost of Goods Sold to a car company is exactly what it sounds like – the cost of and the cost of manufacturing cars, including material, labour and overheads of running a plant.

So, if you want to improve operating margin, you need to increase your EBIT relative to your sales. That means reducing expenses to make a significant improvement. In VW’s case, they will be looking to reduce their selling/general/admin or R&D primarily while maintaining or increasing Sales revenue.

The importance of gross profit margin

The other margin that is a useful measure of a company’s strength is gross profit margin.

What does this tell us? COGS is made up of material, labour and overhead costs. As discussed previously regarding the Swindon situation for Honda, labour and overhead costs are a serious problem when volumes start to go down.

Material Costs

If there are £6,000 worth of materials in a car, and you make 10,000 cars… £60,000,000

If you make 20,000 cars… £120,000,000

100,000 cars… £600,000,000

0 cars… £0

Labour & Overhead

Labour and overhead, however, are linked to the operation of the plant, independent of volume. Labour is based on shifts, typically 2 per day, 5 days a week. This can be flexed to 3 shifts per day or up to 7 days a week but at additional cost.

Labour, therefore, is stepped. If you can build 200,000 cars with 2 shifts, 5 days a week, it might cost you £20,000,000 or £100 per car.

If you build 150,000 but still need the same shift pattern, that’s £130 per car.

Don’t want the shifts? Either pay them even if they don’t work to keep them with the company for brighter times (or because you contractually have to … see the US auto industry crisis 2008-2010) or offer them separation with a one-time financial hit.

Overhead is a similar situation. If the facilities and utilities cost you £50,000,000 per year:

200,000 cars… £250 per car

100,000 cars… £500 per car

1 car… £50,000,000 per car

Gross profit margin shows if you are materially efficient, have optimised workforce costs and high plant utilisation.

Enough with the maths, is 3.8% operating margin good or bad?

There is one additional nuance with EBIT to understand. Many manufacturers now present an EBIT value, but also an adjusted EBIT value. Principally all costs should be balanced with expenses to see the profit or loss, but special items such as one-off sales or purchases of subsidiaries, restructuring costs or pension costs are now removed. PSA refer to them as “Recurring” and “Non-recurring” income and expenses. The sentiment is that the adjusted EBIT better reflects how the company is performing year-on-year.

How about now? Finished the explanations?

VW’s 3.8% is lower than its target of 6%, and 6% has been established as a reasonable target for a mainstream brand. A premium brand such as BMW would target 8-10% operating margin.

I have collated the Non-Adjusted & Adjusted Operating Margins of some of the major automotive brands below, along with the Gross Profit Margin.

Sources: Annual Reports 2018

On an operating margin look, 6% appears to be the mainstream level, with Renault and PSA hitting the number. GM, Ford and Nissan are all struggling at the 3-4% mark. The premium level is around 8%, with Mercedes and Audi nearing that mark and BMW (not shown as annual report was not available at the time) have also dropped just below 8%. Skoda is unusually high, buoyed by strong performance in China.

Sources: Annual Reports 2018

Looking at the adjusted margin, the story changes somewhat. VW’s information was reported as “Operating result before special items” in their annual report, so I have included it here. Notably, GM rises from 3.3% to 8.9% through adjustments relating to their interpretation of “relating to the operation of the business” and restructuring and recall costs.

Now you can see the 8.4% margin reported for PSA or technically Peugeot Citroen DS and excluding Opel Vauxhall, excluding their not-insignificant “non-recurring” restructuring costs.

But VW the brand (vs Volkswagen AG the group) and Ford are still low down in performance.

Sources: Annual Reports 2018

On to gross profit margin, an interesting pattern emerges. The majority of manufacturers have around 20% gross profit margin, including Tesla. Those that don’t are GM, Ford and FCA. This goes some way to explain why GM has had to consider major plant closures in the past few months.

My key takeaway from this is that if you cannot manufacture efficiently, you cannot adequately control costs or boost revenues to compensate.

Finance is tricky!

Financial performance in the automotive industry is a hard thing to deliver. The high level of investment  in both manufacturing and development means that is can be very difficult for smaller manufacturers even if they can build cars efficiently (see Tesla: 22.9% Gross Profit, -17.1% Operating Profit). Tesla’s future will be very interesting, as their revenues have the potential to skyrocket with the high-volume Tesla Model 3 and Model Y.

Making sense of financial reporting is equally hard. I have taken a look into a couple of financial ratios but there are many more that I could look at.

The moral is that the numbers reported in the media have a lot of moving parts behind them and not all is as it is often reported.

What it means for the state of the industry

VW will not be the only manufacturer to restructure. Ford and GM have been in the midst of restructuring. PSA is now profitable after years of restructuring. FCA has been mooted as a potential merger partner by PSA, and would join Opel Vauxhall in the growing automotive powerhouse.

But Volkswagen AG as a group is performing well. Nissan has Renault to lean on (for now). Tesla has the force of nature (and unbridled marketing gold dust) that is Elon Musk. Ford, GM, and FCA have an interesting road ahead, and I don’t expect it to be a smooth 12 months.

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