German automaker Bayerische Motoren Werke AG (BAMXY) finished 2015 on a high note. The company remains firmly on top of the luxury car market, experiencing record sales in several markets. Overall, BMW has managed a strong portfolio of brands, reaping the profits of the portfolio in recent years. The company has been making a concerted push into emerging markets such as India and China. As the economies have improved, more and more people have purchased luxury cars, with BMW sitting at the forefront of the market. However, with China’s economy creeping to a halt, BMW has already seen uncertainty in financial markets directly affecting sales. With other automakers gunning for the top spot in sales and BMW’s line of cars becoming slightly dated, 2016 could prove to be a decidedly more challenging year for the company.

BMW’s Situation

BMW has been at the top of the luxury game for some time. The company became the leading distributor in 2010, and has remained ahead of competitors ever since. In the third quarter of 2015, the company recorded a fantastic 14.00% gain in revenues year over year while profits also rose by an impressive 12.80%. For the year, two of the company’s three brands saw healthy improvements, with Mini and BMW cars raising sales by 6.10% while the motorcycle division increased top line results by a remarkable 11.00%. The only blemish for the year came with Rolls Royce, which saw a five-year streak of sales growth end in China after overall global sales fell by -6.80%.

BMW has proven to be resilient, maintaining a strong position in the industry since 2009, bucking the trend of most luxury automakers and managing to keep sales consistent throughout. Recently, the company has benefited from a general expansion into emerging markets. The company has made a concerted effort to break into India, mostly through its motorcycle segment. BMW is planning on offering two new motorcycles designed especially for the country, and priced much lower than their existing lines. The plan could prove profitable, as India’s premium motorcycle industry has proven to be a major growth proposition, with sales for the second quarter of 2015 up by 39.00% for bikes at or above 200cc. BMW stands to gain big, despite some challenges in the local market.

BMW has also invested heavily in China, increasing their exposure in the world’s second largest economy substantially over the past five years. The company has increased its share of the Chinese market by 10.00% since 2010, and in 2014 controlled 21.60% of the total luxury car segment. Before 2015, Rolls Royce shadowed much of the success of the BMW brand, experiencing five years of increasing sales in the country. All in all, China became BMW’s largest market, with the region accounting for approximately 21.00% of the company’s sales in 2014 alone.

Trouble Ahead

BMW has remained on top of the luxury car industry, and 2015 continued that streak. 2016 however is presenting the company with numerous challenges and headwinds. Globally, emerging markets are struggling to find solid economic footing, and no country has felt this more than China. The Chinese economy has slowed to its lowest growth levels in 25 years, and the effects are already being felt. When combined with the continued crackdown on corruption and displays on wealth, BMW’s niche is likely to see further erosion.

For BMW, the slowing economy has already had an impact on sales. Rolls Royce, which has been a consistent performer in China, saw sales dropped precipitously year over year. After all was said and done, sales of Rolls Royce vehicles in China fell by 54.00% year over year, dragging down global sales by -6.80%. While it was once the driver of sales expansion for BMW, China has now dropped to the third largest market for the company after the US and the Middle East. A more serious crisis in China could cause additional revenue shrinkage even though it retains a spot as a major market.

BMW is also in danger of losing its top position to competition this year. While sales continue to grow, the pace of expansion has slowed somewhat, underlined by key competitors gaining ground. Mercedes-Benz, the second largest luxury automaker, has been narrowing the gap between the two companies, and its sales have continued to grow at a torrid pace. For 2015, Mercedes expanded sales by 13.00% to 1.87 million units, while BMW’s 5.90% growth left it only slightly ahead at 1.9 million units. A large part of the gain can be explained by BMW’s performance in China. The company’s sales growth slowed to 1.70% for the year, while Mercedes sales exploded higher by 33.00%.

The Financial Take

Even though conditions for sales might be deteriorating globally as evidenced by early developments in Asia, BMW remains very fairly priced with a price-to-earnings multiple of 8.62 strongly indicative of a conservative valuation. By comparison, Daimler has a P/E ratio of 9.14 and Volkswagen is valued at 8.79. For income investors, current prices mean an attractive dividend yield of 3.63%, helping to sweeten the deal. However, despite the dividend optimism, with shares falling over 30% from 52-week highs, BMW stock is firmly in a bear market. Sales may remain solid, but cash flow presents a different narrative for investors.

Similar to most companies operating in the current environment, capital expenditures have slowly shrunk, while free cash flow levels have trended into negative territory. Shrinking free cash flow is not necessarily a positive sign, especially for income investors hoping that BMW will maintain the dividend. Should net operating cash flow continue to trend closer to 0, it could raise concerning flags about the outlook for BMW. Currently, fundamentals call for additional Put positions to take advantage of a potential global rout before investors find more attractive dividend yields irresistible. Based on this weakness, investors hoping to capitalize on the company’s relative stability would be keen to wait before establishing Call positions to take advantage of long-term upside.

Conclusion

BMW is looking at a very difficult 2016. While the previous year was record breaking, global conditions and increasingly fierce competition could combine to create strong headwinds for the company. If BMW loses more ground in China, it could see the impact in both its balance sheet and share prices. Further losses in share prices are not unfeasible considering the poor 1-year performance and shares firmly entrenched in a bear market. While the entrance to emerging economies foretells of great riches to come down the road, these fortunes look unlikely to come to fruition in the near-term, suggesting further Put positions to exploit the relative weakness in shares.