Detroit is leaner and greener and ready to meet the pent-up demand of consumers driving aging gas guzzlers.
This article originally appeared in the August/September 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Morningstar’s equity analysts think that auto
stocks are poised for their long-awaited rebound
and that now is a good time for investors
to start easing their way in. The industry is
certainly still full of risks, but we think that
patient investors should be amply rewarded. To
learn more about an industry that hit rockbottom
in 2008 and 2009, I sat down with
analysts David Whiston and Richard Hilgert.
Our discussion took place June 4.
Philip Guziec: Let’s talk about the drama over the past decade in the U.S. auto industry to set the stage for where we’re at now and where the opportunities might be.
David Whiston: Readers who have followed the U.S. auto industry may recall that right after 9/11, GM GM announced its Keep America Rolling promotion. The company threw a ton of incentives into the market and gave everyone employee pricing, escalating a price war that was already under way. U.S. new light-vehicle sales peaked at about 17.3 million in the early 2000s, and we rode that 17 million-plus until things started to slow down in 2007 and ’08. Guziec: So, up until 2007-08, we were selling a ton of cars, but the domestic manufacturers weren’t making any money.
Whiston: Very little. Then housing slowed. People couldn’t use their homes as an ATM machine anymore or buy that Ford F150 as a personal vehicle to take the family to the movies. But the real spark that started the fire was when gas prices went through the roof. In real dollars, gas prices peaked at $4.27 in June 2008.
Guziec: At the same time a recession started.
Whiston: Yes. This was the worst-case scenario for the three Detroit guys because they were so pickup and SUV reliant. They made lousy small cars. Toyota Corolla, Honda Civic, and then Hyundai, came in and ate Detroit’s lunch in that segment.
In the summer of 2008, used Priuses were going for more than new Priuses, which is still amazing to think about. The hybrid technology of GM and Ford F was pretty primitive. It probably still is today relative to a Prius, but it’s much better in 2012 than it was in 2008. Same with small cars. In 2007–08, there was the Chevy Cobalt. Now, there’s the Chevy Cruze. It’s finally a car that can go head to head with the Corolla.
Anyway, by 2007–08, Detroit was losing market share and needed to shrink, but they couldn’t because of their massive fixed-costs obligations. The all-in labor cost for these guys was $75 to $78 an hour. But unions didn’t trust management, and vice versa. Both ways, the hostility was pretty nasty then.
Guziec: So, going through the cycle, the edge of bankruptcy brought the unions to the table enough to allow the companies to shrink to an appropriate size. Rising fuel costs allowed the companies to design small vehicles that people now demanded.
Whiston: The transformation came in two parts. The distress got the unions to the bargaining table in fall 2007, after they struck at GM, to at least get retiree health care off the books through the establishment of the VEBA [Voluntary Employee Beneficiary Association] funds.
But it still took bankruptcy at GM and Chrysler to drastically transform these companies. Ford was able to borrow a ton of money in late 2006, and [CEO Alan] Mulally started turning Ford into a Toyota TM. They got on the commonplatform bandwagon a lot faster than GM did.
Guziec: When did sales bottom out?
Whiston: In 2009 at 10.4 million units, worst per capita year since at least 1951, which is as far back as records go.
Guziec: How many units are we running at now?
Whiston: In 2012, 13.8 to 14.2 million, probably closer to 14.2 million, but mid-14 million is not out of the question.
Guziec: We’re coming out of the slump.
Whiston: Yes. Morningstar has long argued that we’re going to see a pretty healthy recovery. It got delayed last year by the disasters in Japan and Thailand. This year, we don’t have those impediments to supply coming back online. Honda HMC is just about caught up.
Guziec: What is normal U.S. demand?
Whiston: I’ve done analysis that suggests to me that normal demand is between 16.1 to 17.3 million units per year. We still have a ways to go, and that’s the exciting thing about seeing names like GM and Ford trading at absurd valuation multiples. GM is under 5 times our 2013 earnings. GM is barely trading above EBITDA right now. Ford is under 6 times earnings. These are very attractive points. It’s just a matter of how patient do you want to be because the stocks aren’t done selling off with what’s going on in Europe and concerns about the U.S. economy.
Guziec: Theres’s a lot of pent-up demand?
Whiston: Yes, for a couple of reasons. First, used-vehicle prices are at record highs. Eventually, a consumer will come into a showroom intending to buy a used 4-year-old car, look at the price, and walk out with a new or leased car for just a few hundred dollars a month. Plus, for some vehicles, it’ll get 40 miles per gallon without being a hybrid. Also, the age of the average car is at a record high: 10.8 years. You can keep going to AutoZone to buy parts or paying a mechanic to keep it running, but at some point, it will cost more to fix that 15-year-old car than replace it.
Richard Hilgert: There’s also an historic relationship of new driver’s licenses issued to new vehicle sales. There’s been growth in the number of driver’s licenses, but we are still at a very low level of new-car sales. Miles driven has increased a little bit this year, too. We were off a little bit in 2011 versus 2010, which was up significantly over 2009. So, there are all of these dynamics making this pent-up demand that is going to have to get filled sooner or later.
But we’ve got a huge pushback against it in the economy. There’s no homeowner’s equity out in the marketplace, and about 20% to 30% of new car loans were coming from that market in 2004–06. We’ve also got the wealth effect, where the retirement portfolios of baby boomers were hit hard, so individuals who are close to retirement are spending less. Baby boomers have become conspicuous savers instead of conspicuous spenders. Young adults have been unemployed for 24 months or longer in many cases, and college grads can’t find a job. These people are also saving more and might have a behavioral change akin to what occurred after the Great Depression, where younger people became lifelong savers instead of spenders.
Now, at some point the rubber band is going to stretch and snap back. When unemployment and consumer confidence improve, we’re going to start to see better new-car sales. Guziec: So, there’s pent-up demand in the United States. What about in the rest of the world?
Hilgert: Brazil and South America had been setting records year over year, up until this year. Conditions in Brazil look to be flat year over year. China has also been faltering. But again, on a year-over-year basis, we’re looking at a decline from record levels. Russia is a growth area. India is also a fairly large market. They’re also having some economic issues, but again, you’ve got record volumes that you’re probably going to be flat to slightly off on. So, unit volumes around the world aren’t looking that bad, with the exception of Europe. In total, unit volume in the Northern and Eastern European countries will be flat year over year. The Mediterranean countries are having difficulties, of course. They will be down some 20-odd percent year over year.
Guziec: That’s a fairly positive outlook overall. Where are the opportunities for investors? Whiston: I cover GM, Ford, Toyota, and Honda. All of them are cheap, but GM and Ford are my favorites right now. They’re just crazy cheap. They get nearly all of their earnings from the United States, so they are very much a U.S. recovery story.
To break even in 2007, GM needed the U.S. auto industry to sell 15.5 million units and GM needed 25% of the market. Now, they need 10.5 million industry units and 18% to 19% share. Think about that. GM can now break even at a point of basically the catastrophic sales levels that we had right after Lehman Brothers. Their labor costs are dramatically lower. They’re filling some product holes— such as in Cadillac and in full-size pickup trucks. In Ford’s case, I’m really excited to see what they’re going to do with the new 2013 Fusion that comes out in October. It’s a gorgeous car.
Guziec: What about Fiat and Chrysler?
Hilgert: In 2009, when Chrysler went bankrupt, Fiat made an agreement with the U.S. and Canadian governments where they would get an equity holding for coming in to manage Chrysler. It started off at 20% and then it went up by 5% increments for three different performance events, which Fiat met. Fiat then bought out the U.S. and Canadian government. Today, Fiat is a 58.5% owner and the UAW VEBA is a 41.5% owner. Fiat, beginning this year, has an option to start buying stock from the UAW at predetermined prices based on a market formula in 3% increments every six months.
This deal was huge for both Chrysler and Fiat, because it gave each company an opportunity to use each other’s distribution channels across the Atlantic. They shared few markets before. It also offers the opportunity to develop common global architectures. The more commonality you can get across unit volume, the lower your costs. On their own, each company was a 2-million- to 3-millionunits- per-year manufacturer. So, they’re doubling their unit volume, and the potential for cost savings is very large if you can have common parts and architectures across portfolios of vehicles.
The new Dodge Dart is the first integrated vehicle that will come out from Chrysler using a Fiat platform. The platform is also used to make the Alfa Romeo Giulietta and the Fiat Viaggio at plants in Italy, Brazil, and China. Guziec: What is Fiat worth?
Hilgert: We get a fair value estimate of EUR 14 per share, versus a current market price of EUR 3.65. If we do a sum-of-the-parts analysis and break the company down into Ferrari, Alfa Romeo, Maserati, parts supplier Magneti Marelli, and Chrysler, we come up with about EUR 9 a share. Based on our 2013 estimates for cash flow and enterprise value, sum-of-parts values the company at EUR 22 per share. It is a high-uncertainty-graded stock.
Guziec: So, basically, we’re not sure what it’s worth, but it’s worth a lot more than what it trades for today.
Hilgert: As Dave said earlier about GM and Ford, it’s absurdly cheap.
Guziec: What about absurdly cheap suppliers?
Whiston: I cover two suppliers, Gentex GNTX and Johnson Controls JCI, and both are 5 stars. Gentex has only a $3.3 billion market cap, but they have 88% of the auto dimming-mirror market. It’s an absolutely fantastic company, one of my favorites. They have no debt, no pensions, no unions, and $3.92 per share of cash and investments on a debt-free balance sheet. Unfortunately, it trades at a higher multiple because some investors think of them as a technology company. But it still has the cyclical volatility of an auto name. Because of that, it’s a great name to buy after it gets creamed. It gets lumped in with all the rest of the auto industry and sells off, rather unfairly. Gentex pays a yield, too, of a little more than 2%.
Johnson Controls just became a 5-star name today and is also one of my favorite companies. It has three excellent businesses. They make HVAC climate-control equipment, and they have a very nice oligopolistic position in seating. But the battery business, called Power Solutions, is the real jewel of the company and should continue to get some really nice profitable growth from U.S. car companies as they adopt its Start-Stop battery technology.
Hilgert: An interesting 4-star stock is Tenneco TEN. These guys make emission controls and suspension products. Clean-air legislation in the U.S. and around the world is creating new markets for them in heavy and light trucks. TRW Automotive TRW and Autoliv ALV are a couple of other interesting 4-star stocks. They both sell safety equipment, which is also gaining traction in a growing global base.
The best company in the group of suppliers that I follow is BorgWarner BWA fantastic management team who are getting fantastic returns on invested capital. Their goal is 15%. We think that they’ll do 17% this year. Unfortunately, it’s a well-known name, and the market value of the stock reflects it; it’s only a 3-star stock.