BMW AG Profit Slumps On Higher R&D Spending And Rising Costs

German luxury-vehicle maker BMW AG (NASDAQOTH:BMWYY) (NASDAQOTH:BAMXF) said Nov. 7 that its third-quarter operating income fell 27 percent from a year ago, to 1.745 billion euros ($2.0 billion), as the company sharply boosted its development spending on electric vehicles and self-driving technology.

This article originally appeared in The Motley Fool.

BMW confirmed the revised full-year profit guidance it had issued in September.

BMW's third-quarter earnings: The raw numbers

How BMW's business segments performed in the third quarter of 2018

BMW organizes its business into three segments:

• BMW's automotive segment builds and sells cars and SUVs under the BMW, Mini, and Rolls-Royce brands.
• BMW Motorrad, the company's motorcycle segment, builds and sells BMW-brand motorcycles.
• BMW's financial services segment provides financing for dealers and buyers of the company's vehicles.

Automotive

Earnings before interest and taxes (EBIT) in BMW's automotive segment fell 47.1 percent from the third quarter of 2017, to 930 million euros, despite a 3.3 percent increase in revenue to 24.743 billion euros and a slight (0.3 percent) increase in vehicle deliveries.

BMW said "numerous factors" were responsible for the year-over-year decline in EBIT, including:

• Unfavorable exchange-rate effects
• Higher prices for raw materials, notably aluminum and steel
• Heavy discounting by rivals ahead of a change in vehicle-emissions standards in Europe (the new standards took effect on Sept. 1)
• Tariffs imposed in July between the U.S. and China. BMW exports U.S.-built SUVs to China
• Higher "warranty and goodwill" expenses related to vehicle recalls
• Increased research and development spending

As a result of the pressures, BMW's automotive-segment EBIT margin fell to 4.4 percent from 8.6 percent a year ago, significantly below its long-term target range of 8 percent to 10 percent. Sales were down year over year in Europe and the United States, but rose 11.5 percent in China despite a weak overall market.

By brand:

• Sales of BMW-brand cars and SUVs rose 1.5 percent to 506,920. Strong demand for the midsize 5 Series and 6 Series sedans, the small 1 Series, and the new-last-year X3 SUV helped offset declines in sales of BMW's bread-and-butter 3 and 4 Series and the big 7 Series.
• Mini-brand sales fell 6.3 percent from a year ago, to 84,505. Mini's Countryman continues to sell well, but its other models have seen sales decline in 2018 from a year ago.
• Sales of Rolls-Royce's ultra-luxury vehicles rose 14.3 percent, with 878 vehicles sold in the third quarter. The top-of-the-line Phantom sedan was all new last fall; its strong sales (232 sold, versus just 21 a year ago) more than account for the overalls sales gain.

Motorcycles

BMW Motorrad's EBIT fell 37.7 percent to 33 million euros despite a 1 percent gain in global sales, to 39,818 sold. Revenue fell 7 percent to 476 million euros. What happened?

The explanation: Production fell 10.3 percent to 37,172 motorcycles in the third quarter due to a manufacturing changeover as BMW geared up to launch a series of all-new models in the mid-class "Adventure" off-road segment. Like most auto (and motorcycle) manufacturers, BMW books revenue when a vehicle ships; a decline in shipments means a drop in revenue (and thus profit) even if its retail sales rise.

As a result of the decline, Motorrad's EBIT margin fell to 6.9 percent from 10.4 percent in the third quarter of 2017.

Financial services

BMW's captive-finance segment generated revenue of 7.33 billion euros (up 9.8 percent). BMW signed 490,347 new financing and leasing contracts with retail customers during the third quarter, up 12.7 percent from a year ago. But despite the growth, EBIT fell 13.2 percent from a year ago, to 527 million euros. BMW attributed the decline to unfavorable foreign-exchange effects and an increased reserve for litigation.

What BMW's CFO said about the third-quarter result

Nicolas Peter is BMW's member of the board of management for finance, a title equivalent to chief financial officer of a U.S. company. Here's what he said about the profit headwinds BMW faced in the third quarter.

As previously announced, we will be investing a total of around one billion euros more in research and development of new technologies this year. As communicated at the beginning of the year, the R&D ratio increased to 6.9 percent in the third quarter. We knew from the start that 2018 was never going to be easy.

In addition to high upfront investments in future projects, we are also facing currency and commodity headwinds in the high three-digit-million range, as expected. These already challenging conditions intensified even further over the course of the summer.

On the cost side, we began implementing countermeasures early on. In addition to prioritizing more strictly, we also decided on a number of short and long-term measures in recent months.

In light of the challenges I referred to, additional efforts will be needed to support our profitability targets.

Peter didn't explain what "additional efforts" BMW plans to make to reach its profitability goals.

Looking ahead: BMW confirmed its reduced full-year guidance

BMW released a statement cutting its full-year profit guidance on Sept. 25. Peter reiterated that reduced guidance with the third quarter earnings report.

For the full year, BMW expects:

• Automotive segment revenue "slightly lower" than its 2017 result. ( 2017 result: 88.6 billion euros.)
• Automotive EBIT margin to be "at least" 7 percent. (2017 result: 9.1 percent.)
• A "moderate decrease" in overall group profit before tax. (2017 result: 10.65 billion euros.)

BMW reiterated that it now expects a "significant effect" on group profit before tax and the EBIT margin in its Automotive segment in its fourth-quarter results. But it continues to target "slight increases" in deliveries to customers in the Automotive segment for the full year.

John Rosevear has no position in any of the stocks mentioned. The Motley Fool recommends BMW. The Motley Fool has a disclosure policy.