May 3, 2012

Peugeot Earnings hit a speed bump

by Sridharan Raman

Around the world, auto manufacturers are in the midst of a revival – and to keep it going, they’re filling airtime on your local television channels with ads for their latest models. It seems to be working – after a strong 2009 was followed by a bumpier 2010, sales went into overdrive again last year. And while US automakers are beneficiaries of the trend, it is a global phenomena, as the chart below, portraying year over year changes in new car registrations in Europe, clearly illustrates. The demand for cars has soared in China and India along with the ranks of middle class consumers in both countries; most car companies are battling for a share of some of that growth.

French auto manufacturer Peugeot (PEUP.PA), however, seems to have arrived at the party a little too late. It didn’t enter China until 2010, years after most its rivals had already whipped up enthusiasm for their own brands. In India, Peugeot actually arrived too early – it first began trying to sell there 15 years ago, only to leave when its sales never took off. Now it’s planning a second assault on the Indian market, with hopes it will do better this time around. But for now, the relative lack of exposure to high-growth emerging markets is one of the factors that may be weighing on Peugeot, whose weak StarMine Earnings Quality (EQ) measure of 11 indicates that the company’s profits may not be sustainable in the future.

StarMine uses computer-driven models to analyze the financial statements of thousands of publicly-traded companies, and to calculate a proprietary StarMine Earnings Quality (EQ) scores for each of those businesses. Those companies recording the lowest StarMine EQ scores are the least likely to be able to sustain their past earnings track record. (For a more detailed explanation of this model, please refer back to this recent article about the earnings quality of American Express.) This examination of Peugeot earnings is the first installment in a series of articles looking at the earnings quality of companies across Europe that rank either especially low or high by our quantitative measure.

One warning sign that a company’s profits may not be sustainable into the future is when it begins to report poor free cash flows (FCF). In the chart below, the red segment of each bar represents the amount by which Peugeot’s free cash flow lags its net income. As can be seen in the chart below, Peugeot saw a loss of 218 million euros in the second half of 2011, while free cash flow plummeted and turned negative, to the tune of 1.2 billion euros. Research has shown that earnings backed by strong FCF tend to be sustainable, so it may be worthwhile for investors to take a second look at Peugeot’s results.

Source: Thomson ONE / StarMine

Another factor contributing to Peugeot’s low StarMine EQ score is the company’s gross margin, which is falling. That means the company either is charging less for its cars, or that it is spending more to build them. As you can see in the chart below, the gross margins at Peugeot have been falling steadily for the last decade. In fact, in the last 6 months, ended December 31, the gross margin was only 17%, almost 5 percentage points below the industry median of 21.9%. Furthermore, both the company’s operating margin and its net margins languish below industry medians. That slump in margins could produce lower corporate profits in the coming months.

Source: Thomson ONE / StarMine

Finally, Peugeot has been increasing its capital expenditures (CapEx) since 2009. However, the cash flow from operations has been falling for the last 18 months. In the last reported semiannual period ended December 31, -, Peugeot’s capital spending totaled 1.3 billion Euros, far in excess of the cash it generated from its operations, which totaled only 117 million euros. Some of that CapEx increase may be a result of Peugeot’s expansion into China and India, with the company anticipating that future sales eventually will offset those higher costs. But whenever CapEx is not funded from operations, it tends not to be sustainable. Companies can’t just spend their way out of trouble.

Source: Thomson ONE / StarMine

At the moment, it is the French election this weekend rather than the future earnings prospects of French companies that are grabbing media attention. But the same issue that is at the heart of the election debate – the fragile European economy – is likely to weigh heavily on Peugeot and other companies in the region that rely on consumers’ willingness to open their wallets and spend on big-ticket items. Certainly, Europe’s automakers may find that their sales within their domestic market take a hit, casting a cloud over Peugeot’s biggest market. If its efforts to enter the developing markets don’t pan out, Peugeot may see earnings fall even further. For now, the weak StarMine EQ score of 11 warns investors that the company’s earnings may remain weak in 2012.

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