By Bob Ciura

When income investors think of auto stocks, they typically think of the U.S.-based giants Ford Motor Company (NYSE:F) and General Motors Company (NYSE:GM). Both stocks have high dividend yields above 4%. General Motors is Warren Buffett’s 2nd highest yielding stock.

But there are auto manufacturers outside the U.S., that are just as attractive from a dividend perspective.

One of them is Daimler AG (OTCMKTS:DDAIF), which sports a 5% dividend yield.

Daimler’s dividend yield is above its peer group because investors are worried about economic conditions in Europe. The European economy was already on shaky ground heading into 2016, and the summer Brexit vote only added to the uncertainty.

As a result, Daimler shares have dropped 12% since the beginning of 2016.

While Daimler faces a unique set of geopolitical risk, it also offers above-average return potential. The stock is very cheap, with a high dividend yield, and the company itself is performing well.

This article will discuss Daimler and its merits as a dividend investment.

Business Overview

Daimler is a major auto maker, based in Germany. The company operates in six core segments:

  • Daimler Group (49% of sales)
  • Mercedes-Benz Cars (30% of sales)
  • Daimler Trucks (10% of sales)
  • Mercedes-Benz Vans (4% of sales)
  • Daimler Buses (1% of sales)
  • Daimler Financial Services (6% of sales)

The stock has declined throughout 2016, but the underlying company fundamentals remain sound.

In 2015, net profit increased 21% from the previous year. This compelled the company to raise its dividend by 33%.

The strong results have continued into 2016. The third quarter was particularly strong.

Source: December 2016 Investor Presentation, page 3

The best-performing segments last quarter were Mercedes-Benz cars and Mercedes-Benz vans, which grew revenue by 12% and 13%, respectively.

This growth is more than offsetting weakness in trucks and buses, which is expected to continue for the full year.

Source: December 2016 Investor Presentation, page 13

Growth Prospects

Despite the uncertainty presented by the Brexit vote, Daimler’s growth prospects remain positive. The company remains focused on its four core strategic initiatives.

Source: December 2016 Investor Presentation, page 17

Daimler management foresees trucks and buses nearing the peak of the current cycle. However, the company still sees plenty of growth opportunities in cars and vans. As a result, it is placing continued emphasis on maximizing these brands.

Source: December 2016 Investor Presentation, page 22

New vehicle launches should fuel growth. And, Mercedes-Benz has a key advantage, which is that it operates on the premium end of the pricing spectrum.

As a luxury brand, Mercedes-Benz is somewhat insulated against economic uncertainty. Higher-income consumers can better withstand a mild economic dip.

Separately, Daimler is working on other growth initiatives, including electric vehicles and even autonomous vehicles.

Source: December 2016 Investor Presentation, page 42

Autonomous cars are still far from becoming reality. But, if Daimler is successful in bringing these technologies to market, it could make meaningful market share gains against its competitors.

Competitive Advantages & Recession Performance

The auto industry is fiercely competitive. Auto makers have to constantly battle each other for customers. This heightened level of competition typically leads to significant discounting, which is one reason why industry profit margins are so low.

One barrier to entry used to be start-up costs. Scale benefits allow only a few major auto companies to claim the majority of market share in the U.S. and internationally. As one of these, Daimler benefits from its size.

It has a market cap of $82 billion, which provides it with the financial strength to invest heavily in growing the business:

  • 2014 R&D expense of $11.9 billion
  • 2015 R&D expense of $13.8 billion
  • 2016-2017 projected R&D expense of $30.2 billion

Auto manufacturing is extremely capital-intensive. Historically, it has been very difficult for new car companies to start up and develop, to the point where they are generating enough profits to compete on the scale of the industry leaders.

However, the recent and seemingly overnight success of Tesla Motors (TSLA) seems to put this into question.

As a result, there do not seem to be significant barriers to entry. This means there are not many clear competitive advantages for Daimler to rely on.

In addition, auto makers are among the most vulnerable to recessions.

Daimler’s earnings-per-share fell steeply during the Great Recession:

  • 2007 earnings-per-share of $5.55
  • 2008 earnings-per-share of $2.37
  • 2009 earnings-per-share of $1.74
  • 2010 earnings-per-share of $5.34

Fortunately, the company quickly recovered. By 2010, earnings-per-share nearly retraced the decline of 2008-2009.  The company cut its dividend in 2009 and did not pay dividends in 2010.  Dividend payments resumed in 2011.

Valuation & Expected Total Returns

The market seems to be overly pessimistic about Daimler, given its resilient sales and profits this year.

The good news is that this presents investors with an attractive opportunity. Daimler stock is cheap. Shares trade for a price-to-earnings ratio of 9. By contrast, the S&P 500 has an average price-to-earnings ratio of 26.

Investors should not expect Daimler to trade up to a market multiple, as auto stocks typically have discounted valuation multiples.

But even a modest increase in the valuation multiple could yield significant returns. For example, a price-to-earnings ratio of 13-15 would generate 44%-67% returns.

Moreover, future returns will be supplemented by earnings growth. Some analysts are predicting an imminent auto recession. Sales and earnings may decline, due to rising gas prices and interest rates.

However, analysts on average expect Daimler to grow earnings-per-share by 2% in 2016, and 7% in 2017.

Based on this, a reasonable expectation for future returns could be as follows:

  • 4%-6% sales growth
  • 1% margin expansion
  • 5% dividend yield

Therefore, even when using modest assumptions, Daimler stock could return 10%-12% per year, excluding any expansion of the price-to-earnings ratio.

Final Thoughts

Daimler stock has performed poorly this year. But investors could be too negative on the stock.

The company continues to perform well. Fear is running rampant, as it often does. Investors tend to sell first and ask questions later.

But those willing to buy the stock when few are, may be rewarded over the long-term. And, until the fear subsides, investors are paid well to wait.

For these reasons, investors should view Daimler as an attractive income stock with growth potential.