Global Research 18 March 2019 Fundamental Analytics Equities Behind the numbers: Autos Global Valuation, Modelling & Accounting Geoff Robinson, CA FCA Analyst [email protected] +44-20-7567 1706 Julian Radlinger, CFA Analyst [email protected] +44-20-7568 1171 Renier Swanepoel Analyst [email protected] +44-20-7568 9025 Patrick Hummel, CFA Analyst [email protected] +41-44-239 79 23 Guy Weyns, PhD Analyst We launch the second of our series of collaborative sector analyses … [email protected] The Fundamental Analytics team has teamed up with the UBS Global Auto Sector team +65-6495 3507 (17 analysts across six regions) to deliver the second in its series of collaborative reports Paul Gong (see the first one on pharmaceuticals here). This report focuses on all things Autos. It is Analyst written to (1) provide investors new to Autos with an exhaustive overview of everything [email protected] that's relevant to understand the sector from an industry and company perspective, (2) +852-2971 7868 help new and seasoned investors alike frame their financial statement and earnings Colin Langan, CFA quality analysis, and (3) provide a guide to the most commonly used accounting Analyst practices and pitfalls specific to the sector, how to spot them, interpret and adjust for [email protected] +1-212-713 9949 them. This report is the go-to Global Auto sector hand-book for equity investors. Kohei Takahashi … including a detailed global sector run-through … Analyst Our report starts with a ~50-page sector primer written on the basis of the combined [email protected] expertise and wealth of resources of the UBS Global Auto Sector team. We examine the +81-3-5208 6172 industry top-down and bottom-up, and build the bridge between industry structure, Eugene Jung short- and long-term trends and value generation (or destruction) in the sector. New to Analyst Autos? Start with this. Seasoned Auto investor? Make this your sector hand-book. [email protected] +82 2 3702 8801 … an OEM finco deep-dive … Sonal Gupta Over the next ~10 pages, we shine a light on one of the least well-understood parts of Analyst the industry, the OEM fincos. We analyse over a decade's worth of data to conclude [email protected] +91-22-6155 6063 that (1) fincos should be seen as cash generators during times of auto industry decline and (2) simple finco valuations (e.g. 1.0x P/B) may understate both the value in core David Lesne finco operations as well as the potential value in new, still loss-making mobility services. Analyst [email protected] … and a global Autos earnings quality and accounting screen +44-20-7567 5815 We then round off the report with an analysis of critical accounting issues specific to Yizhe Wang Autos. We look at key differences between US GAAP and IFRS and their potential Analyst impact on reported earnings, including examples and our view on how to make [email protected] +852-2971 8007 adjustments. As part of this exercise, we screen the global UBS Autos coverage (58 stocks) along the most commonly used accounting rules that impact reported earnings, and rank them on the basis of most to least conservative in their accounting practices. For illustrative purposes, we show all companies under the most conservative practices and the impact to net income this would have – which is over 20% in some cases. www.ubs.com/investmentresearch This report has been prepared by UBS AG London Branch. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 158. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Geoff Robinson, CA FCA Contents Analyst [email protected] Executive summary .......................................................................... 4 +44-20-7567 1706 Insights into Global Autos ............................................................................ 4 Julian Radlinger, CFA Analyst [email protected] Understanding OEM fincos .......................................................................... 7 +44-20-7568 1171 Critical accounting issues in Autos ............................................................... 9 Renier Swanepoel Analyst Insights into Global Autos ............................................................. 10 [email protected] +44-20-7568 9025 How the industry makes money ................................................................. 10 Patrick Hummel, CFA Analyst How OEMs make money ........................................................................... 11 [email protected] +41-44-239 79 23 How parts suppliers make money .............................................................. 22 Guy Weyns, PhD Analyst How tire makers make money ................................................................... 29 [email protected] +65-6495 3507 Why macro matters: interest rates, raw mats, FX ....................................... 31 Paul Gong It's the cycle, stupid! Or is it? ..................................................................... 34 Analyst [email protected] +852-2971 7868 Cash is king in auto-land ........................................................................... 36 Colin Langan, CFA A look in the rear-view mirror: Autos in the past ........................................ 39 Analyst [email protected] +1-212-713 9949 Autos go global – international expansion … ............................................. 40 Kohei Takahashi … and into the dragon's den: entry into China .......................................... 41 Analyst [email protected] The dragon learns to fly: Chinese OEMs ..................................................... 45 +81-3-5208 6172 Eugene Jung The golden era of Autos: not over yet (or is it?) ......................................... 46 Analyst [email protected] Where to from here? Disruption is the name of the game ......................... 48 +82 2 3702 8801 Sonal Gupta To start: emissions regulation … ................................................................ 49 Analyst [email protected] … the European diesel decline … .............................................................. 51 +91-22-6155 6063 David Lesne … and vehicle residual values .................................................................... 53 Analyst Medium term: Electrification ...................................................................... 55 [email protected] +44-20-7567 5815 Long-term: shared mobility … ................................................................... 58 Yizhe Wang Analyst … and autonomous driving ....................................................................... 59 [email protected] +852-2971 8007 Reading material ........................................................................................ 61 Understanding Auto Fincos ........................................................... 62 What operations are included and how material are their contributions? ... 62 Are fincos outperforming OEMs? ............................................................... 63 How profitable are these operations? ........................................................ 64 What is the finco's cash flow impact on OEMs? ......................................... 67 How should fincos be valued? ................................................................... 68 Whose accounting is most conservative? .................................... 69 R&D capitalization ..................................................................................... 70 Fundamental Analytics 18 March 2019 2 Associate income accounting ..................................................................... 71 Pensions accounting .................................................................................. 71 Critical accounting issues in Autos ............................................... 72 Key US GAAP versus IFRS issues ................................................................. 72 R&D capitalisation ...................................................................................... 75 Equity-accounted investments .................................................................... 88 Pensions .................................................................................................... 94 Other accounting issues in Autos ............................................... 100 Rebates, incentives, credits and warranties .............................................. 100 Pre-serial production costs ....................................................................... 105 Pre-production engineering costs ............................................................. 107 The accounting for tooling ....................................................................... 115 OEM prepayments ................................................................................... 117 Impairments............................................................................................. 119 Loss-making contracts ............................................................................. 130 Asset-backed securities ............................................................................ 132 Appendix ...................................................................................... 135 Pension accounting: The detail ................................................................