Automakers: Dead End, or Open Road Ahead?
The massive decline in auto sales last year suggests a large recovery is coming.
U.S. auto sales have recently rebounded from lows not seen in decades. Despite the recovery, automakers still have plenty of issues to deal with over the coming years. Below we discuss light-vehicle sales and where we think they are going, challenges from new fuel-efficiency rules and the industry's excess capacity, and then close with our thoughts on some of our OEM names including ones that are getting cheap.
U.S. light-vehicle sales data since 1951 helps put the recent sales crash in perspective. 2009 sales were only 10.43 million vehicles, quite a decline from the decade's high of 17.35 million in 2000. The last time sales were close to 10.43 million was 1982's 10.36 million (see top chart, shaded bars denote recession years).
Graphing the data on a per capita basis--both relative to the number of licensed drivers and the total population (bottom chart)--reveals that 2009's results were even worse than the early 1980's. Dividing 2009 sales by our estimate of the total number of licensed drivers (about 210.4 million) gives a per capita sales ratio of 0.05--the lowest ever back through 1951. The ratio was 0.069 in 1982 and the next lowest ratio after that came all the way back in 1958, at 0.063.
With the recent sales pace worse than when the country had 61% fewer drivers on the road in the late 1950s, we think it is reasonable to expect a strong sales recovery over the next few years. Sales through May are already heading toward 11.5 to 12 million units for the year, and barring a double-dip recession we expect that upward trend to continue beyond 2010. Looking at our auto sales and total population data, and multiplying the 2009 U.S. population by the average sales per capita for 1951-2009 gives a mean reversion sales total of 15.90 million vehicles. Another proxy of normative demand would be the same multiplication using a more recent per capita sales average. For example, using the per capita average from 1976-2009 implies a normative demand of 17.31 million vehicles.
Although the sales story looks bright for automakers, other challenges remain, including new Corporate Average Fuel Economy Standards (CAFE) and the industry still having too much capacity. New standards from the National Highway Traffic Safety Administration (NHTSA) and the Environmental Protection Agency (EPA) should make the U.S. vehicle fleet more fuel-efficient, but also more expensive for consumers. Starting with the 2012 model year, NHTSA's CAFE rules keep increasing miles-per-gallon requirements for cars and light-trucks to a combined 34.1 mpg by the 2016 model year (37.8 for cars and 28.8 for light-trucks). The EPA administers the Clean Air Act, and its provisions call for a 35.5 mpg fleet level by the 2016 model year. NHTSA's rules are a 4.3% annual increase from the 27.3 mpg combined level for the 2011 model year. The two agencies have slightly different rules because credits for air-conditioning improvements can be used to meet EPA standards but not NHTSA standards.
Automakers can make vehicles this fuel efficient through a variety of aerodynamic and parts improvements such as turbochargers. The key question is will Americans want the smaller vehicles that these fuel economy rules will push the fleet mix toward? If gas prices do not return to levels seen in 2008 then the answer is probably no, and auto sales may not grow as fast as they would absent the government rules. Since CAFE was passed in 1975, there has been a major disconnect in the U.S. between the government wanting more fuel efficient vehicles while the free market favors large vehicles. In other words, Americans have never had much incentive to buy a small vehicle unless that is what they really wanted or was the only vehicle they could afford. May's auto sales saw the car/light-truck mix down to 53.5% cars from 54.7% a year ago, suggesting that current gas prices are not high enough to keep Americans buying cars rather than crossovers or other light-truck models as demand improves. The government could increase its tax on gas guzzlers or subsidize hybrids and electric vehicles as it will later this year, but we think the best way for the government to achieve its objective would be to dramatically increase taxes on gasoline as is done in Europe. We are not advocating higher taxes; we just believe that if the government really wants to shift the vehicle mix to more fuel-efficient models, then a gas tax is the best way to incentivize consumers to buy smaller vehicles. To paraphrase recently retired GM executive Bob Lutz, the current U.S. policy is like forcing overweight people to lose weight by only allowing tailors to make small sized clothing.
If the U.S. government is successful in pushing more consumers toward car models over light-trucks, the irony is that it would hurt the Detroit Three more than foreign automakers. Sales data from Automotive News shows that through May, the Detroit Three only sold 32.5% of U.S. car models. Despite the excellent improvement in Detroit's car designs, the transplant automakers still have an advantage in cars while Detroit does very well in light-trucks, with 60.1% of that market through May. New models such as the Chevrolet Cruze should help Detroit narrow this gap, but the Detroit Three still have a long way to go.
Excess manufacturing capacity is another problem all automakers are dealing with. Toyota (TM) for example, stopped construction on its new Mississippi plant for well over a year and closed the NUMMI plant in California (after old GM pulled out of the NUMMI joint venture) because it already had millions in excess unit capacity worldwide. In its 10-K, Ford Motor Company (F) cites research from CSM Worldwide that global excess capacity is enough to build an average of 21 million extra vehicles a year through 2014. Some of this gap may be closed as sales rise, but so much extra capacity also suggests more plants need to be closed and even that some automakers need to liquidate. Union labor and politicians' aversion to rising unemployment rates makes plant closures difficult, a key reason why there have been automaker bailouts in nations such as the U.S., Canada and France. However, we think these bailouts may just be putting off the inevitable day of reckoning for weaker automakers such as Chrysler. The U.S. market is only becoming more competitive as smaller firms such as Hyundai and Volkswagen (VOW) try to increase their U.S. share, which is bad news for weaker incumbent firms. Only time will tell who has the best products to stay alive.
As for actionable ideas, we currently do not have any five-star automaker calls but Daimler (DDAIF) and Toyota are two names that we think offer significant upside to investors. Daimler is a stock that could be very cheap if the European debt crisis ever leads to another sell-off like the one suffered in early May. We think Daimler is very well-positioned for a weaker euro due to slightly more than half its sales coming from outside Western Europe (21% alone from the U.S. in 2009). The weaker euro makes Mercedes-Benz cars more affordable for consumers in Daimler's international markets. In the first quarter, for example, the U.S., China, and U.K. were the second-, third-, and fourth-largest markets for Mercedes-Benz cars. All of these areas have seen the euro weaken relative to their own currency, which suggests Mercedes should continue to do well despite turmoil in Europe. China is the largest market for the expensive and very profitable R-Class and S-Class, so more mix shift to these bigger models would be great news for Daimler. Germany is the firm's largest market at about 24% of 2009 company revenue, and that nation's finances are in much better shape than other European countries. Even after the crisis erupted in Greece, Daimler announced on May 28 that it is maintaining its return on sales target for Mercedes-Benz cars of 10% by the second half of 2012. The unit posted 7% margins in the first quarter of 2010. We also expect the truck group to rebound strong in late 2010 and 2011 as the North American economy gradually improves. We see Daimler as a stock that could be unfairly sold off due to fears about Europe, which would create a buying opportunity.
Toyota's stock sold off nearly 22% once its sudden acceleration problems became worldwide news. Although this issue damages the firm's ability to differentiate itself from competitors via quality, we still think highly of the firm's long-term earnings potential. CSM Worldwide forecasts global light-vehicle production to rise to 89.5 million units by 2016, up from 66.9 million this year. We expect Toyota's earnings to grow as the industry recovers and we are not worried about the legal risks from sudden acceleration lawsuits. The company's balance sheet is a fortress with consolidated cash and investments as of March 31 of more than JPY 4 trillion ($44.5 billion). Excluding the financing arm, cash and investments total more than JPY 3.1 trillion ($34.3 billion), so the company has ample liquidity to get through its legal problems and still fund operations, in our opinion. Given that British Petroleum (BP) is setting up a $20 billion escrow fund for damaging the Gulf of Mexico, we expect Toyota's cash damages to be far less for tragedies that have impacted a very small number of people directly. Assuming a $5 billion settlement, for example, only reduces our fair value estimate by $4, or 3.5%. The long-term threat to Toyota does not come from legal risk; it comes from the firm operating in a fiercely competitive and capital intensive industry where it is hard to differentiate from the competition. The recall crisis makes this differentiation much harder for Toyota, since some consumers no longer think of Toyota as a brand with vastly better quality than American automakers. This perception makes the firm compete more on price, which is usually a race to the bottom due to high capital expenditure and R&D requirements. All of these reasons are why automakers are not a wide-moat business.
General Motors Company is likely to file for an IPO this year or in early 2011, depending on market conditions. We will not publish a fair value estimate until after we read an S-1 and build a discounted cash-flow model, but we will discuss our preliminary thoughts on the new GM now. We think GM's earnings potential is excellent because it finally has a healthy North American unit and can focus its marketing efforts on just four brands instead of eight. The most critical cost-savings measure was setting up a Voluntary Employee Beneficiary Association (VEBA) for the retiree health-care costs of the United Auto Workers union. This move saves GM about $3 billion a year and other wage and benefit concessions have drastically lowered GM North America's breakeven point. The actual point varies based on mix and incentive levels but the CFO's comments on the first-quarter earnings call imply that GM's North American business breaks even at a U.S. light-vehicle level of around 11 million units, assuming current market share. As discussed above, U.S. light-vehicle sales as high as 17.3 million units is not unreasonable, so we expect GM to be printing money as vehicle demand comes back over the next few years. The largest threat to profitability right now is the company's European operation, which has been losing money for a long time and will now require restructuring without assistance from European governments.
Our calculations put the maximum number of GM common shares between 500 and 616 million. Before old GM (now called Motors Liquidation Company (MTLQQ)) got into distress, its diluted share count was 566 million, so new GM's common share count is not dramatically different from the old company. The new GM also has preferred stock, which old GM did not, taking some value away from common shareholders in addition to a $27.4 billion underfunded pension as of year-end 2009. Despite drastically less debt and the strong outlook for the company, GM will still have to offer great products such as the Buick LaCrosse, Buick Enclave, Chevrolet Malibu, Chevrolet Camaro, and Cadillac SRX to get consumers past the stigma of taking taxpayer money. We think the American public is willing to accept the new GM as long as there is great product. Sales for the four core North American brands (Chevrolet, GMC, Buick, and Cadillac) have been strong since the company exited bankruptcy. In GM's May sales release the company said "year-to-date sales for GM's four brands have risen 31 percent to 874,749 units � an increase of 206,994 units compared to last year, which is almost twice the volume lost from brands the company has discontinued."
Ford's strategy will be to reduce debt while making great cars and trucks. Now that Mercury is finally being terminated, the company looks very similar to Toyota, with one volume brand and one luxury brand. Ford is on the right track and just needs the consumer to be confident and the credit markets to not freeze as they did after Lehman Brothers collapsed. Leasing data from Automotive News shows that for the industry, leasing was 19% of first-quarter U.S. retail vehicle sales, up from 14.3% in the first quarter of 2009 but not back to the recent peak in the first quarter of 2008 of 22.1%. Leasing is a critical part of selling vehicles due to the low monthly payment, so more leasing is good news for all automakers. We see no reason to lower our fair value on Ford as long as our thesis of a gradual recovery in auto demand remains in place.
Although auto manufacturing is a terrible quality business, the stocks can be attractive at certain points in an economic cycle, such as near the end of a recession. It is almost impossible to perfectly time the bottom of a cycle with consistency, but knowing which stocks have the best balance sheet can give an investor confidence to ride out the massive volatility auto stocks bring to a portfolio. We think the worst is over for the auto sector, and we are very optimistic about light-vehicle sales growing dramatically over time in both developed nations and emerging markets.
David Whiston does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.