Where Can the Automotive Industry Go From Here? Part 2

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. What people want to drive is changing. There’s pent-up demand to buy, trade in, and trade up. Morningstar Research Services’ U.S. autos equity analyst Dave Whiston shared this industry outlook in Part 1 of “Where Can the Automotive Industry Go From Here?” He explained why he thinks carmakers already experienced a recession. So, check out Part 1 in case you missed it. Now, Dave talks about the shift to electric vehicles and two cheap stock picks.

As you mentioned, uncertainty centering around the economy, you’ve written that there are reasons to be optimistic about U.S. auto demand. One of them is that many people are driving old cars. Let’s talk about that.

Dave Whiston: The fleet age, basically, it tends to creep up every year. I mean, cars are more durable than they were, say, in the 70s, for example. But there’s also a certain element of people putting off a purchase for economic reasons or because the inventory just hasn’t been available in the past few years. You can do a lot of maintenance but you can only defer certain things forever, and then accidents can still happen, or you have a major powertrain issue, gasket work, something like that can be really expensive. So, you might just say, “OK, it’s time to buy a new car.” There’s also safety reasons, honestly. When I first started years ago, I used to cover Autoliv ALV, a company that does a lot of safety equipment. They loved to show safety videos at the end of the presentation. I still remember one where they took a giant big—they’re Swedish, so they took a big Volvo—station wagon that was older than a smaller car that they had and then they smashed them head-on. And you’d think the big station wagon will win that battle, right? No, that giant station wagon, it folded up like a paper cup. And that’s always struck me, and I always remembered that. So, for those that have the means, I think just for safety reasons, I think it’s helpful not to have a car for 15-plus years just because the safety features do get better, and the structural integrity of the steel body and whatnot, it gets better over time.

So, in addition to safety, there’s other reasons you might want to buy a new car. Your lifestyle needs may change. Your families get bigger or smaller. Of course, you might be forced to because you had an accident. Your car gets totaled. But there’s also just the tech and safety in a car is so different in 2023 than it was in, say, 2007 when I started following the industry. I mean, now you’ve got 4G Wi-Fi in vehicles, and even 5G is on its way. You’ve got passive and active safety like lane departure and all the lidar radar sensors, things like that. If you want to spend a lot of money, you can do things like Tesla’s TSLA autopilot mode—a term I use generously because that’s what they call it—and their FSD [full self-driving] technology. And then, GM’s GM got their Super Cruise technology, and they’ve got Ultra Cruise coming out on the Cadillac Celestiq very soon. I think that’s next year or late this year, and that can drive on about 95% of all the roads, you just need to still be paying attention. So, there’s a lot that’s different even compared to, say, 2015, too. So, there’s just a lot of reasons to get a new car if you’ve got an old one. And then, also, you’ve got the continued trend of more Americans wanting light trucks, which are pickups, crossovers, minivans, SUVs. I think in the last month it was 80% of all new light vehicles sold in the U.S. were light truck models. So, there are always people that have that Honda Civic or Corolla, let’s say, from 2009, but over time, more and more those people have traded up to a light truck such as a crossover. Crossovers are north of 45% of sales.

Hampton: With the new safety features and other tech gear inside of cars, how are automakers going to convince people to buy or lease a new car?

Whiston: Whether you want to buy or lease the vehicle, I think ultimately it’s about having the right level of inventory, and we’re just not quite there yet. You’ve got two competing forces this year, and then you’ve got poor affordability and rising rates combined with inventory finally starting to get better but still is a ways to go. So, it will be interesting to see. I haven’t seen consumers completely walking away yet, but you never know if things get worse. I mean, interest rates, my opinion on this and I’ve asked some dealer CEOs about this, they’re high and the average new-vehicle payment right now is over $700 in this country. And if you want to lease, it’s like $578 in the fourth quarter. That’s too high. As trim packages get wider and you get some lower-option trim packages, I think that will bring pricing down, too. But rates right now on the new vehicle side, it’s a little over 6% on average. We can probably go, by my math, the sensitivities as high as that payment change using 69.4 months or so as the loan term, there will be 100-basis-point increase. What does that mean to the rate? Generally, it’s something like $18 a month. But 100 basis points is one thing. If you start to get, I guess, well north of 10%, I would get more concerned. So, I think the Fed can raise rates a bit more. Will they? Remains to be seen. Perhaps the recent regional bank contagion risk and the collapse of SVB and Signature Bank, maybe that will give the Fed reason to pause or at least moderate its rate increases. We’ll just have to wait and see how that plays out. But it’s going to be choppy and lumpy. I mean, what would really scare me would be do rates go back to 1982 levels when a new-vehicle loan rate was nearly 18%. That would be a disaster. But hopefully, we will not go there. I don’t think we will. But obviously, you never know.

Hampton: Will the trend of new-car loan terms stretching out, will that trend continue?

Whiston: I think on duration of a loan, I mean, it’s roughly 69.4 or 69.5 months right now on average. You do have some seven-, eight-year loans out there, not a ton. But there’s only so much you could do with a car going to say a 30-year car loan like you do with a mortgage, it doesn’t make any sense because the collateral profile on a house versus a car is totally different. And generally, someone who buys a new car, they might hold it on average roughly five to six years. So, I think it will creep up a bit, one, because pricing is high, and that’s one of the key ways you can manage that monthly payment. For the consumer, a lot of times it’s all about just what is the monthly payment. It’s not even what is the interest rate. They just want to get the monthly payment to something that works in their budget, and that’s the way you can do it is with the long-term, to a point.

One thing to keep an eye on too, though, is the risk of negative equity, which is, when you’re trading in, do you still owe money on that car that you’re trading in. It’s weird. I see fewer mongering articles about this in the press quite often. I’ve asked the dealers I cover about it. They never seem worried about it. They always feel like they can work around it, and they have honestly, and for the most part, they do third-party lending with a few exceptions. But their third-party lenders seem to be willing to make it work somehow, generally if they roll the negative equity into a new loan. So, that could keep sales maybe—I wouldn’t say it’s going to freeze sales, but it might prevent sales from getting to, say, 17.5 million immediately after the chip shortage is over. But it will be an issue for a bit just because you’ve got people who have bought and now pricing is coming down, they may need to hold on a bit longer before they buy.

Hampton: Can you explain this shift and why drivers are now favoring crossovers and SUVs over sedans?

Whiston: Light trucks, they fell to about 45% of new light vehicle sales around ‘08 or ‘09. You’ll recall before Lehman Brothers collapsed gas prices were sky high and you had things like a used Prius was selling for more than a new Prius because everyone was freaking out about gas prices. But over time that mix has now gone up to 80%, as I mentioned earlier. I think there’s a couple of variables there.

One, there is a bit of a stereotype, but I think it’s a stereotype because it’s true. Most Americans do like larger, bigger vehicles. They feel safer. They feel like they have more command. They feel they can see better if they’re up high. I’m in the minority here, but I still personally prefer sedans. So, I don’t think sedans will go away. But crossovers have made it a lot easier to go into truck, especially if maybe you aren’t a minivan person; some people are, some people aren’t. But you’ve got a lot of options now. Whereas before, if you didn’t want a sedan, you had to go all the way up to, in the industry we call it, body on frame SUV. Think like a Cadillac Escalade, Chevy Suburban, Tahoe, really big, hulking vehicles like that. Those were actually made on a full-size pickup truck platform. Crossovers, on the other hand, are what’s on, in industry parlance, what’s called unibody construction. Basically, the same kind of platforms and body of a car. You just rejiggered some things to make the vehicle higher and have more cargo space. And so, basically, you don’t have to give up fuel economy now, at least not in any severe way to get more space, and sometimes the pricing isn’t all that different, either.

Just an example. I’m going to mix vehicle segments here. But take the Camry as a typical midsize family sedan. Back in the day, that would have perhaps been your family vehicle before crossovers. And then, one of the leading compact crossovers out there is the Toyota RAV4. So, looking at starting prices, the RAV4 only starts at about roughly $1,800 more than the Camry. So, ignoring interest rates if you just divide that out over—I think I did this over 69 months, if I remember right—but that comes out to an extra, I think, $27 a month. So, it’s not a lot per month pricewise to go up there to the RAV4. And then, in terms of fuel economy, according to the fueleconomy.gov, on a combined fuel economy basis, you’re only losing two miles per gallon between a Camry and a RAV4. So, it’s not a big difference, but then in terms of cargo volume with the RAV4, you get about 2.5 times more cargo space. So, it makes it easier to switch up to a light truck and then you throw in things like feeling safer or higher, whatever drivers’ preferences and now you’re at light trucks at 80%.

Hampton: Mention electric vehicles and the name that probably comes to mind is Tesla. You’ve written that GM is the one to watch. Why Dave?

Whiston: Tesla is still the leader in terms of the all-electric segment or what I call BEV, or battery electric vehicle, all-electric vehicle. Tesla is still the number-one player. They have a little over 60% share last year. That’s down from, I think, 77% a couple of years ago, basically because the industry—and the GM’s been a leader in this—the industry is finally making an effort to, because they see a path for making EVs profitably, they’re actually making desirable BEVs now rather than these awful econoboxes that would get 80 to 100 miles on a charge and, of course, nobody wanted. Go figure, right?

So, when you look at GM’s EV portfolio now, people probably think of the Bolt and the Bolt EV, but there’s a lot more to it than that. Those are actually on an old battery platform now, and that one is under recall. But the new platform Ultium is not under recall, and there hasn’t been fire risk at least in a major way reported with Ultium yet to my knowledge. So, you’ve got vehicles now like the Hummer pickup truck that’s already out. In, I believe, 2024, the Hummer SUV EV comes out. Cadillac Lyriq crossover is already out, and that is, I think, a very worthy competitor to the Tesla Model Y. Now, there’s charging network differences that Tesla has the supercharging network, and the other automakers don’t. Although Mercedes wants to go that path; we’ll see how that works out. But personally, I’ve been critical of Tesla’s interiors. I mean, yes, it’s a modern futuristic interior. But to me, it’s just not luxurious and worth the price point. For what they charge, I think they should offer a better interior. And you get that now when you look at like a Mercedes EQS, you look at the Cadillac Lyriq, for example. These are good looking, desirable EVs, which with a good range, up and around the 300-mile range per charge.

And then, there’s more coming from GM. You’ve got the Silverado EV that this year. The Sierra comes out next year, I believe. And then, this fall is really interesting. You’ve got a few crossovers: the Blazer EV and then this fall is the Equinox EV. That’s going to start at $30,000. And I think this is going to be a very interesting vehicle to watch because this is the first true high-volume attempt to go after the mass market customer with an EV that’s actually desirable in terms of range and amenities and whatnot. So, it’s going to be interesting to see does that Equinox do really well whereas, say, something like the Tesla Model 3 has done very well. Can the industry get success in EVs beyond Tesla? I think GM’s Equinox is going to be a really good—I hate to use word experiment—a really interesting thing to watch in terms of the mass-market adoption of EVs. At a bit higher price point and in a different segment, you look at something like the Ford Lightning pickup truck EV. That has done a very well. So, I’m optimistic for the Equinox. But ultimately, we’ll see what happens. But yeah, there’s a lot coming from GM, and they do believe in an all-electric feature. I believe both Cadillac and Buick will be all electric by 2030, and their whole company they see going all electric by 2035.

Hampton: GM is calling itself an auto tech company. Can you explain why they’re doing that?

Whiston: That’s the term I heard CEO Mary Barra using in an interview. There’s a lot going on at GM and really in the whole auto industry beyond just selling cars now. In GM’s case, you’ve got several new businesses. They outlined all this in October 2021 at an analyst day, and they were just some pretty aggressive financial targets for 2030. But they’re looking now for $25 billion in revenue by 2030 in what they call SES, just software enabled services. This includes $6 billion from OnStar Insurance, which is already commercialized in the marketplace, and also $10 billion to $15 billion of revenue for various subscription services. And this will be for a wide range of things like you could possibly get Super Cruise or Ultra Cruise on a subscription basis as opposed to just buying it up front. Or you could do things like customize various things in your vehicle, whether it’s the console display to be personalized to something you like. I think they used an example in the slide deck of the PGA Tour if you are a golf enthusiast. But you can expand this over time, too, especially as you get perhaps more quasi semiautonomous capabilities in vehicles where you could do gaming, e-commerce, infotainment, augmented reality, virtual reality even. There’s all sorts of things, perhaps, down the road you could do with that. But again, $25 billion of revenue on nascent to nonexistent businesses today.

GM is talking about $80 billion in revenue by 2030 from things that are either nascent or nonexistent today, and the single biggest piece of that $80 billion is $50 billion by 2030 for their Cruise autonomous vehicle subsidiaries, which they own a little over 80% of along with some other big players like Honda HMC and Microsoft MSFT. Cruise is really interesting, and I don’t think GM gets enough credit for this at all. That is level 4 autonomous technology, meaning geofence autonomy, and that will have the Cruise origin. It’s supposed to start being produced this year. That just has a passenger area. There is no drivers console area. That is an autonomous vehicle. I’ve been inside it. It’s quite spacious and comfortable. Tons of legroom. You just get in and it looks like a giant pod, basically, and it will just take you within any geofenced area in the city it’s operating in. They are already offering commercialized where consumers for level 4 robo-taxi services in San Francisco, Austin, Phoenix, and they’re the exclusive robo-taxi provider starting this year for Dubai. So, this is the kind of thing I think if Tesla was doing it, it would be considered amazing. But when GM does it, they don’t seem to get the credit they deserve.

Hampton: The audience can probably sense that GM is one of your picks. Dave, lay out your case.

Whiston: I’ve said this for a while, and I know it’s been frustrating at times. It’s gone up, it’s gone down, and mostly it’s been getting held back. There’s always a fear of when we’re going to have a recession. Well, you just had it in 2020. You look at the cash flow and the EPS GM is delivering, to me, it doesn’t seem worthy of a company that should be trading at a forward P/E multiple of 5 to 7, 6 to 8 times, but that is the reality. This is a radically different company from old GM. They can break even now in North America at what would be basically 2009 sales levels, which in my opinion we probably won’t even see again anyway. And even if we did, I think with the per capita population math you’d be at more like 11.4 million now or 11.6 million, something like that, not 10.4 million like we were in ‘09. So, you’d be at a higher volume anyway. But a much more different company.

And then, the 2030 financial targets they outlined in October 2021, that’s $300 billion in total company revenue, adjusted EBITDA margin of 12% to 14%. If you do the math on that at an assumed tax rate and you assume no more share buybacks between now and 2030, even though they are buying back shares, you would get to an EPS of $20. And if you even keep the P/E multiple close to where it’s been, do 8 times, that’s a $160 stock. That’s more than 4 times where it’s trading right now in mid-March. And if you discount that back to the present, it’s only within a few dollars of my current fair value estimate actually.

So, to me, I think people need to realize that new GM is much more efficient than it used to be. They’re capable of generating probably in the range of $8 billion to $10 billion a year in free cash flow in terms of automotive free cash flow. You’ve still got a growing captive finance arm because they had to start their finance arm from scratch. Remember, they got rid of GMAC and then bought AmeriCredit, and they’ve rebuilt that in terms of GM Financial, and that’s no longer just a subprime lender. That’s mostly a prime lender now.

So, for me, current stock levels in the $30 range, I just don’t think that makes any sense. I mean, obviously, there’s a lot of fear right now. I’m not blind to that fact. And yes, inflation is going to be an issue probably beyond 2023. But GM has shown that they can execute in difficult environments. And again, with these new SES services, with Cruise going to get a lot bigger, especially in the second half of this decade, that’s where most of Cruise’s revenue growth is going to come is going to be post-2025. You’re looking at a company that over time its EPS should keep growing well above the $7.5. It did a little less than $8 a share last year. But you can certainly get beyond double digits here because it’s not even selling those data services to consumers. You can sell it to governments, too. With OnStar Insurance and other data the vehicles are collecting, they can do things like, say, well, this is where in your community people are wearing their seat belt or not wearing their seat belt. This is where you have potholes. This is where you may have potholes. This is where you need to do road maintenance. And according to GM’s research every dollar in maintenance that a taxing authority puts off on fixing a road, that eventually costs them $7 later. So, if you can get smarter with the data, GM can sell that data and help bring in some more asset-light revenue, which will be higher-margin revenue than selling cars, of course. But ultimately, you still have to have a great product at the end of the day.

Hampton: Well, let’s move to your other stock pick. This auto supplier is really cheap. Tell us why Gentex GNTX is a buy.

Whiston: Yeah. Gentex and CarMax KMX are really two of my favorite names that I cover in terms of the business quality. They’re great stories, great companies and both are rarely cheap, and both are undervalued right now. We’ll stick with Gentex because you asked.

Gentex, you may not have heard of them, but the odds are, if you have an auto-dimming mirror in your car, Gentex made it. They have about 90% market share of all the world’s auto-dimming mirrors. It’s done through electrochromic technology, basically. With Gentex basically you’ve got a debt-free, cash-rich balance sheet, a fortress balance sheet. And they’re buying back a lot of stock now. They’re much more aggressive about it. Since the current CEO, Steve Downing, took over, started 2018, they’ve reduced their diluted share count by 20% during his tenure. They do pay a modest dividend as well.

But again, you have the dominant market share, a debt-free balance sheet. So, it’s a name for me that I like to mention to clients for those that are apprehensive about investing in the auto industry because it’s highly capital-intensive, it’s highly cyclical. Some people don’t like the union thing. There’s a lot of reasons to hate the auto industry. I get that. But if you look a little deeper, there’s some really interesting names out there, especially in the supplier and dealer space that are perhaps off the people’s radar screen because they just think of the OEMs like GM, Ford F, Toyota TM, et cetera. But Gentex is a great company with really tech-company-like margins and more comparable to Garmin’s margins in terms of EBIT margins and to an auto supplier. They’re way above the other auto suppliers that are out there. EBIT margins are north of 20%, gross margins generally in the mid-30% range to upper 30% range if things are going well.

It’s been held back a lot because of the chip shortage that’s hurting all the suppliers right now because they can’t get the volume. And there’s a lot of inefficient manufacturing going on in all suppliers because they’ll be ready to do a batch for a customer and then the last second, the customer says, never mind, we don’t have the parts. We have to not make that vehicle right now. So, that trickles all throughout the supply chain upstream. But that will eventually get better as the chip shortage gets better. So, I do see Gentex as undervalued. It’s not drastically undervalued to the point where you’re going to double, in my opinion. You’re not going to, certainly going to I think where you’ve got to my fair value estimate, you’re going to double your money or triple your money from current stock price levels. But it’s an attractive name that’s very high quality, and for those that are apprehensive about the auto industry, I think it’s a great name to think about or at least have on your radar.

Hampton: All right. Well, Dave, thank you for your time today and your insights into the U.S. auto market.

Whiston: All right. Thank you.

Hampton: That was Part 2 of “Where Can the Automotive Industry Go From Here?” Be sure to check out Part 1 if you missed it. Thanks to Dave for sharing his auto industry outlook that included why 2024 could go in one or two ways. I’m thanking lead technical producer Scott Halver and senior video producer Jake Vankersen. And thanks to everyone who checked out today’s episode of Investing Insights. Subscribe to Morningstar’s YouTube channel for new videos from our team. I’m your host, Ivanna Hampton. I’m a senior multimedia editor here at Morningstar. Take care.

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