Continental: Lots Of Uncertainty For This Stock

Thesis

Continental (OTCPK:CTTAF) manufactures tires, automotive parts, and industrial products. Some of these products include passenger cars, commercial vehicles, tires, braking systems, transmission products, etc. The business sells to global customers. Zooming into the latest results, I still don't know how I feel about the stock. The new margin guide of 5.5%-6.5% is encouraging, but I think it carries tons of execution risk. This is especially concerning given there is still a lot of unpredictability in the market, and CTTAF's execution over the past three years has been a mixed bag, as evidenced by the constant need to adjust its guidance. As a result, I am waiting with cautious anticipation for improvement in the upcoming quarters. Furthermore, I believe the ability to achieve guidance heavily weighted on 2H23 given that I expect 1H23 to see more pressure from inflation. Overall, I recommend sitting this one out until we see things progressing as guided/planned.

4Q22 results

CTTAF reported 4Q22 revenues of €10.3 billion and adj. EBIT of €497 million. Results were pretty much in-line across the board with no special outliers. Adj. FCF came in at €200 million for FY22 and was lower due to the build-up of inventories and receivables and higher capex. Diving into the other metrics, Auto order summed up to more than €23 billion, growing 26% over last year. Inflation is still a headwind to the business, representing around €3.3 billion headwind in FY22. In terms of opex, something worth highlighting is number of employees were up 4% to around 200,000 head.

Thoughts on auto guidance

In my opinion, the earnings report was centered on the outlook. Sales projections of €20.5–€21.5 billion and adj. EBIT margins of 2%–3% for the auto were better than expected. To put things into perspective, the new guide suggests more than 30% in cons EBIT increases at the midpoint, which suggests to me that CTTAF has a lot of pricing to negotiate with its customers. That said, I remain skeptical as I expect that OEMs' unwillingness to pay for incremental inflation will once again have an effect on CTTAF auto margins this year. In particular, I expect that the rising cost of electronic components will have a notable impact on the CTTAF's overall material procurement budget. In addition to electronic parts, I also believe inflation to be persistent from labor and energy, which may be more difficult to recoup (i.e., how to pass through this cost effectively). Aside that, I believe there will be incremental R&D cost in FY23, which will pressure on margins, in the wake of record order intake in 2022. Generally, I have my doubts about whether or not CTTAF can "walk the talk" after issuing such guidance. In addition, the larger the acceleration in growth and profits needed for 2H23 to hit full year guidance, the weaker the 1H23 performance.

Thoughts on tire margin guidance

In contrast to auto guidance, I believe that the CTTAF tire business can realistically achieve a margin outlook of 12-13%. Although sales and pricing may remain stagnant, the company's expenses should improve, leading to a better cost profile. Specifically, CTTAF may benefit from lower material and logistics costs, as well as an increase in replacement sales after the first quarter, when inventories should stabilize. It is worth noting that CTTAF has not recently announced a price increase, leaving room for potential price hikes later in the year. Although sales volume may remain steady, I anticipate strong growth from price increases and a favorable product mix. However, the elimination of the positive inventory valuation effects that boosted earnings last year could have a negative impact on the company's earnings this year.

Long-term questions remain

When looking at CTTAF stock from a longer-term perspective, I think the most important part of the story is a plausible way to restore auto margins. While CTTAF's success in recouping inflation from OEMs is encouraging, it does little to allay worries about the industry's structural outlook, where new entrants are driving up investment costs and threatening market share. Even though I think it's great that 2022 will set a new record for orders received, investors should keep in mind that this growth isn't coming from high-performance computers or advanced driver assistance systems. There has been only modest commercial success from these high growth factors over the past few quarters, and they are still loss-making due to high investment costs. I have the belief the OEMs are always looking to capture a larger piece of the pie, and vertical integration seems to be the best way, in my opinion. As such, time is not always on CTTAF side. CTTAF long-term story, in my opinion, is partially underpinned by how successful the commercial progress is for its high growth areas.

Conclusion

The FY22 earnings report for CTTAF provided some encouraging signs for the future, but I remain cautious about the stock's outlook. While the new margin guide for the auto sector is positive, there are still many uncertainties in the market, and CTTAF's execution over the past few years has been inconsistent. The tire business, on the other hand, seems to have a more realistic chance of achieving its margin outlook. However, the long-term story for CTTAF remains unclear, especially regarding the success of its high growth areas. As such, I recommend sitting this one out until we see more progress and clarity in the company's performance and market trends.

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