Auto Industry Shifts Gears
Investors who look beyond recalls will see an industry focused on new technologies.
If you long for the days when you could get a sense of the automotive industry merely by visiting Detroit, you're not alone. Getting a handle on the sector now involves a thorough understanding of what's happening in Washington, D.C., China, Germany, Japan, a host of other foreign countries and companies, and, now, even Silicon Valley.
The automotive industry has never been more complex and never more fascinating. I recently talked with Morningstar analysts Dave Whiston (senior equity analyst covering U.S. and Japanese automakers, suppliers, and dealers), Richard Hilgert (equity analyst covering automakers and automotive parts suppliers), and Rick Tauber (director of corporate bond research) to find out what we should know about automakers, their suppliers, their regulators, and the developing technologies that are likely to end up wildly changing the ways we get around. Our discussion has been edited for clarity and length.
Question: Let's get started by talking about the recall issue--which companies is it affecting and to what extent?
Whiston: General Motors (GM) is getting an awful lot of negative publicity, again--this time for its ignition-switch recall. Once that scandal happened, GM basically decided to clean house. In terms of what the victim compensation is going to cost them, we're not sure yet, but I've opted on the side of conservatism. I assumed a $7 billion reserve. That's in addition to about $2.5 billion of recall repair costs in the first half of 2014. But even that $7 billion only decreased our fair value estimate by $4 per share. There's risk, of course, but this isn't something that's going to derail the company.
There are just going to be a lot of negative headlines. I know some shareholders are uncomfortable with that. But you have to look past the headlines and do your homework on the balance sheet and their financial situation and their turnaround. Their sales in the United States aren't being affected by this recall one bit.
It's also important to look at this from the political angle. The United States spent $50 billion to save GM. Canada also spent billions of dollars. You've got more than 50,000 unionized workers in the United States working at GM. I don't see the Justice Department doing something that would cripple GM's turnaround, but I do expect GM to eventually settle for at least $1 billion.
Recalls are a global issue, though--remember what happened to Toyota (TM) a few years ago. No automotive CEO wants to be in front of Congress getting grilled. Also, you've got a lot more common-parts manufacturing and global platforms now. So, when something goes wrong with a part, it's going to affect vehicles all over the world.
Question: How does the international marketplace look?
Hilgert: Europe is recovering from six consecutive years of declines. We're expecting Europe finally to be positive this year, between 2% and 4%. That recovery began in the second half of 2013, and we think that it's going to be a protracted recovery. You've got to consider the austerity measures over there, and the European market is very much used to getting some type of incentives from government programs, either tax incentives or cash-for-clunker types of incentives.
That's just too difficult for the governments to do at this point with the austerity that's going on. The exception is Spain, which actually raised its value-added tax (VAT) to 21% from 17% back when they were getting a bailout. They had to do something, because their sales dropped by 67%. So, given that their sales were down so much with their VAT going up, they decided to offset some of that with a cash-for-clunkers program, which has really boosted sales in Spain dramatically--15% to 20% some months. Still, Spain now is at an annualized rate around 700,000 to 800,000 units, which is really down from its peak of 1.3 million units a few years back.
In the rest of Europe, France is still weak. The United Kingdom is strong. Germany is strong. And Italy is still weak. Altogether, like I said, I expect a sales increase of 2% to 4% this year, but that's starting from of a very low base.
In China, light vehicles will probably increase around 8% to 10%. Total vehicle sales there are staggering--approximately 24 million. Compare that with U.S. sales this year of around 16 million. So, China is the largest market by far at this point.
In South America, we've still got weak economic conditions. We're expecting Brazil might be down as much as 10% this year.
Globally, you put it all together, with China doing as well as it is, offset by the weakness in Europe and South America, and with U.S. increasing, global demand will probably see a slight increase this year.
Question: Should equity investors be concerned about the credit profiles of this sector?
Tauber: The industry is somewhat bifurcated when you look at the Detroit Three, with the bankruptcies or near-bankruptcies they dealt with, and the rest of the global players, which have remained pretty highly rated. We've got ratings of A for Toyota and Honda (HMC), A– for Volkswagen (VOW) and BMW (BMW), and BBB+ for Daimler (DAI) and Nissan (NSANY). The credit quality has held up quite well at those foreign entities, for the most part.
But we have seen a resurgence domestically. For example, we had Ford (F) rated BB in 2010, and now we've bumped them up to investment-grade, BBB–. And I think there's upside from there. The rating agencies have caught up to our ratings and are now also at BBB– for Ford.
We also have a BBB– rating on GM's credit, which is sort of a resurrection after their trip through bankruptcy in 2009. As Dave said, GM's balance sheet is substantially improved. They should be able to fairly easily absorb the costs related to their recall. Those costs will probably delay a couple of the rating agencies from bringing them up to investment-grade, but the path has been laid; I think they're going to get there.
Question: What are the factors right now that you consider when you're thinking about whether any of the auto companies are undervalued or overvalued?
Whiston: In GM's case, you've got to look past the recall and whatnot, but you still have an automaker that's in a turnaround. It takes a long time to turn around a battleship. I think that they still have a lot of margin expansion because they haven't leveraged all the economies of scale they should. Ford gets better margins in North America than GM, but globally speaking, GM sells just less than 10 million vehicles a year, while Ford sold 6.3 million last year. So, GM should get better economies of scale. Alan Mulally, the ex-CEO, turned around Ford sooner in terms of adopting common platforms.
For some perspective, in 2010 GM had 30 platforms. They're going to have 17 platforms by 2018. In 2010, 39% of their volume was on global platforms; today, it's 77%; they're targeting 96% by 2018. So, they still have a lot of economies of scale to gain. Also, they had some programs that they put the brakes on during their bankruptcy--in particular, the full-size sedan, which is the Chevy Impala now, and then the pickups and SUVs on the new K2XX platform. Those just came out late 2013 and 2014.
You've still got some new models coming from Cadillac, like the ATS Coupe. And I think late next year we're finally going to see that rearwheel-drive flagship Cadillac sedan to rival the BMW 7 Series and the Mercedes S Class. Then there's GM's pretty healthy balance sheet and a pension underfunding that improved considerably last year thanks to rising discount rates.
In Ford's case, they're doing a record 23 launches globally this year, so they're incurring a lot of launch costs right now. They're not going to get a lot of the revenue on that until next year.
In the meantime, you're getting a pretty healthy dividend yield from both companies. GM's yield is over 3.5% as of early August, and Ford's is around 3%, both of which are much better than the S&P 500's yield of around 1.9%. So, you're getting paid to wait.
There's a lot of hair in the auto industry. It's not for everybody. It's a volatile industry and very cyclical, obviously. But if you're willing to look past headlines and dig a little, I think patient investors can be rewarded.
Question: Rich, you analyzed Fiat (FCA) in the April/May issue of Morningstar magazine. Do we still like the stock?
Hilgert: Fiat is a great story of integration and cost reduction as much as it is a story about revamping a staid set of brand names that really haven't had the kind of global exposure that they deserve to have. Even though it's globally recognized, Jeep has really never truly been a global brand. Fiat is going to take Jeep global. Maserati has just been a very small niche player, but it's also a globally recognized brand. They're going to do more to bring more of that volume out, as is Alfa Romeo. There'll be more of that product hitting more countries around the world. With that, along with more global platforms and common parts and manufacturing sharing around the globe, we should see some cost reduction coming out of the system, so you've got higher revenue over a more efficient cost base. It should mean some better profitability.
We're not expecting Fiat to set the world on fire with its new margins, but the amount of expected improvement isn't being recognized by the Street at this point. That makes it a 5-star-rated stock. We've got a fair value estimate of 14 euros, and the stock trades around seven and change. So, we're still very confident in our valuation on Fiat.
On the flip side, we would advise investors to wait on investing in many of the auto suppliers. Many of those names are in 2- or 1-star territory, meaning our fair value estimate is below where the market is currently trading. Continental (CON), Magna (MGA), and BorgWarner (BWA), for example, are all excellent companies, but the stocks are overvalued compared with our fair value estimates. The consensus Street-price targets that are out there are even higher than where the stocks are trading at in some instances. We think the supplier stocks should trade at more-reasonable multiples than they are.
There are some suppliers that are in 3-star territory. Gentex (GNTX) is reasonably priced and Johnson Controls (JCI) has been in 3-star and more recently 4-star range. But the rest of the group, at this point, looks to us to be overvalued.
Question: What are your thoughts on new technology in the industry, and relatively new entrants, like Tesla (TSLA)?
Hilgert: Tesla is a small factor right now relative to the rest of the auto manufacturers. The problem is that their vehicles still require charge that lasts 30 to 40 minutes versus a gasoline refill that takes three to five minutes. I think that's a significant limitation when consumers think about a vehicle they could use on long trips.
We'll see about emerging technologies. Toyota is planning to bring fuel cells out in 2015. A lot of people were skeptical about their hybrids in the early 2000s when the Prius was first introduced. That technology in that vehicle has expanded to just about every other manufacturer on the face of the planet, with the exception of Renault Nissan, which is skipping the whole hybrid trend and going straight into all-electric. However, their technology lags Tesla's.
Whiston: Tesla is very intriguing. I just wonder who keeps buying the stock. They're going to sell more than 35,000 cars this year, according to their own commentary. GM and Toyota will sell roughly 10 million each, and yet Tesla's market cap is more than half of GM's. I don't think that makes a lot of sense even if you want to pay for potential. They're not a tech company; it's an auto company with option value on both autos and energy storage.
Tesla certainly is a disrupter in the industry, however. They're doing a lot of things right. They've come up with a really outstanding car that is also pure electric. It has range of 265 miles, unlike the Nissan LEAF, which has an average range of 84 miles. And, frankly, the Nissan LEAF just isn't that good-looking of a car, especially relative to Tesla's Model S.
Currently, the Model S is being bought by very wealthy people. A fully loaded Model S in the United States can go for well over $100,000. In the next few years, Tesla is going to roll out the Model X crossover and what they're calling their Model 3 vehicle, which will be a sedan, smaller than the Model S and priced around $35,000. I assume that's after a $7,500 federal tax credit. Will consumers who can afford at that price point take the plunge and buy an electric car as their primary vehicle? Model S owners probably have Porsches, Mercedes, and Audis in their garages. But will a family of four go for it?
Yes, Tesla's done a great job, and it's very much expanding that supercharging network so you can drive from San Francisco to Los Angeles and even Los Angeles to New York. But what if you want to get away from the major interstates? Until it has the infrastructure of charging networks spread out as much as gas stations are, Tesla is facing challenges to get to get the scale it needs to compete with Toyota, Volkswagen, and GM.
Question: What about self-driving cars? How do you guys see those evolving?
Whiston: I think that's coming a lot later than what people at Google (GOOGL) say. The costs are still ridiculous. That device Google puts on top of the car costs something like $15,000 or $20,000. That doesn't include the price of the car. But surprisingly enough, the government seems very willing to pursue this angle. But self-driving cars are years away.
Hilgert: We're seeing safety technology penetrating into mass-market vehicles. Technologies like lane departure, which will nudge a vehicle back into its lane if it's drifting. There's also automated braking, which kicks in when the car is getting too close to something.
Active safety technology can do a lot of things to either mitigate or completely avoid an accident. It requires enough sensors around the vehicle and enough processor capability to calculate that information and make an assessment. Then, it needs enough computer power to activate either brakes or steering or a combination of these things to make the vehicle do what it should to mitigate or avoid an accident.
These are some of the initial steps toward semi-autonomous vehicles. Then, we'll start to see vehicles that will be able to drive themselves maybe out on the highway and in areas that are regulated for these kinds of vehicles. That's different than a vehicle being completely autonomous, where you get in, tell it to take you home, and it drives you there all by itself, or you use your cell phone to tell the car to pick you up. Those sorts of things are probably not going to happen in the next decade; it's going to be much longer than that.
Vehicle-to-vehicle and vehicle-to-infrastructure communications are in development and will enable every vehicle to communicate with every other vehicle around it. There will be various communication points along roadways, so vehicles will know where they are relative to road infrastructure--such as traffic lights, intersections, on- and off-ramps--and relative to other vehicles on the road. This will enable semi-autonomous driving.
Whiston: Consider the ramifications of all this, like insurance and liability. Also, if we have this world in which you simply tell your car to take you home, that revolutionizes what you do with a car's interior. You don't need the front seats and back seats. Maybe you just have plush couches all throughout your car, or your car is an office.
Hilgert: I agree on all the considerations and ramifications. If I'm in a self-driving car and somebody else is in a self-driving car, and neither one of us is driving, who's at fault if, for some reason, there's an accident? Whose insurance covers it? Is this a manufacturer defect? Would there have to be a recall? Would this mean that the insurance is going to need to have some kind of backing from the auto manufacturers? A lot of issues will need to be solved.
This article originally appeared in Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.
Basili Alukos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.