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The Achilles heel for German luxury manufacturers like BMW, Mercedes and Audi was always going to be small cars, but the sudden dive in the value of the euro against the dollar might have changed all that.

As investors contemplated the German companies’ confident long-term profit forecasts of close to 10 percent towards the end of this decade, several hurdles emerged. Maybe the extraordinary profits generated in China would dry up? But consensus now is for a gradual decline to more normal profits, rather than a possible shake-out as the market collapsed.

The big rally in the U.S. market was a huge boost to profits, but that won’t last forever. If the U.S. dips, maybe Europe will rally, or maybe even emerging markets will stop submerging sometime soon? Either way, the swings and roundabouts of global demand would even out profits for the Germans and allow them to fulfill their rosy forecast.

One thing though surely couldn’t be avoided. The moves in the U.S., China and Europe to force vehicle manufacturers to radically cut fuel consumption – to the equivalent of 57.4 miles per U.S. gallon in Europe in 2021 and 54.5 mpg in the U.S. by 2025 and something unspecified as yet but similar in China – meant downsized small cars were unavoidable. And everybody knows that you can’t make money with small cars, right?

Wrong, if your currency, the euro, plunges close to 20 percent against the dollar and other global currencies.

“With a near 20 percent move in the (euro-dollar rate), these low margin products are suddenly much more profitable,” said Max Warburton, analyst with Bernstein Research.

Warburton said he has been concerned about the impact on profitability, particularly in the U.S., of the German premium makers if they were forced to move downmarket into lower-margin small cars. Mercedes, BMW and Audi have all invested huge amounts in small cars like the Mercedes A class, CLA and Smart, BMW’s 1 and 2 Series and Mini, and the Audi A3 and A1. Mercedes - the M-Class and G-Class - and BMW – X3, X5 and X6 - now make many big, high profit margin SUVs in the U.S., while Audi is about to start making some (the Q5) in Mexico. Most small cars are currently made in Europe and shipped to the U.S.

Modest

“The price and profitability of these (small) vehicles will be modest compared to the larger cars. But does currency change the game,” Warburton asked.

Warburton thinks maybe, but not many others agree with him, although they also expect the solid profit margins they’ve predicted for the end of the decade to be attained anyway. And it’s not just the CO2 regulations driving the move downmarket. The upper echelons of the market are becoming saturated, so if the luxury companies are going to continue expansion, they have to make more smaller, cheaper vehicles, which also lets them strike early in finding new buyers and hope they remain as they age, prosper, and can afford more upmarket, high-margin products.

Philippe Houchois, London-base auto analyst at investment bank UBS, said the weak euro has benefitted German auto companies, has helped them fight off a trend for flat or falling profits and also underpinned them as they fight off the higher costs of investment in new technology to meet CO2 rules.

Houchois cautioned though that the euro weakness might reverse itself. He believed that long term profit targets like BMW’s eight to 10 percent range “weren’t unrealistic”. Before the China boom, predictions of profits in this range were often not believed, and yet reached around 12 percent, thanks to China.

Excess earnings

“An element of excess earnings was in there from China and that won’t continue. Now the new source of excess earnings could be currency and from that standpoint (profits) probably can stay in the eight to 10 percent corridor,” Houchois said.

Sabine Bluemel, automotive analyst at Creative Global Advisers (UK) LLP, agrees that China will slow down, but far from crashing profits, they will resume a more normal trajectory. As China and the U.S. inevitably slow down, maybe emerging markets will take up the slack. They can’t rely on Europe rallying.

“Western Europe is not really growing and sales aren’t likely to reach pre-recession levels until 2021. They have to become more international, growing capacity outside Europe to where the new markets are,” Bluemel said.

The tumbling euro helps.

“The longer the euro stays weak, the better,” Bluemel said.

Bluemel isn’t worried by the move to smaller cars and its perceived impact on margins.

“I’m not worried by downsizing. They can downsize the body and volume of the engine but use turbo-charging to still get the power and can charge money for that,” she said.

How do you feel about the profit targets?

Feasible targets

“Positive. They are feasible profit margin targets. BMW and (Volkswagen’s) Audi have shown that. Mercedes is catching up too with a tremendous new product lineup,” she said.

Anna-Marie Baisden, Head of Autos Analysis at BMI Research, said it would be unwise for investors to rely on euro weakness.

“These things can be very transitory. It’s not really a long-term solution,” Baisden said.

She looks to the drive for electrification and investment in plug-in hybrids, which all three German manufacturers are committed to, although this might be a hard sell in the U.S. where fuel prices have dived more than in Europe. BMW has led the way with its i3 battery only city car (with range extender option), and the i8 plug-in hybrid sports car.

“It’s hard to see a big profit margin in the i8, but it is helping other products in the range, like BMW’s new X5 plug-in hybrid. BMW has learned a lot from the “i” series,” Baisden said.

Can these plug-in hybrids and battery cars ever be profitable though?

“It depends on where you sell them and the infrastructure. In Germany they are falling well short of (sales) targets; it depends on where they are going to sell them. As for making a profit, plug-in hybrids stand more of a chance, because they avoid the range-anxiety of current battery-only cars. If oil prices say low, it’s going to be a problem finding willing buyers. This might trigger a revisiting of the U.S. fuel standards; there’s been a massive interest in bigger cars since fuel prices fell, ” Baisden said.

But Bernstein Research’s Warburton believes the weak euro may give German small cars a dramatic profit lift, but as for overall profitability, he sees risks.

Economics changed

“Selling small cars in the U.S. that are built in Europe did not look like a great business last year. The risk to margins for the Germans was evident. But the huge move in foreign exchange this year – between 15 and 20 percent depending on the day, likely changes their economics. All the German cars sold in the U.S. will be more profitable now,” Warburton said.

But that’s not enough to keep Warburton happy.

“We are worried about deteriorating end markets – particularly China. We worry about the economics of small car programs. We worry about rising development costs. But we have to acknowledge that currency is a big offsetting positive for the Germans. These are massive exporters and the large move in the exchange rate will enhance the results of their U.S. and even Chinese businesses,” Warburton said.

Neil Winton, European columnist for Autos Insider, is based in Sussex, England. E-mail him at neil.winton@btinternet.com

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