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No Reason to Doubt Automaker Turnaround

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

After hitting the skids amid the financial crisis, many automakers are now back on track, but what does the road ahead look like?

Here with me to offer some insights is Morningstar senior equity analyst Dave Whiston. Dave was named one of the Wall Street Journal's Best on the Street analysts earlier this year. Thanks for joining me, Dave.

David Whiston: Thanks, Jason.

Stipp: So we do know that automakers have come a long way from the depths of the downturn. Ford recently reinstated a dividend, which I think is a good sign that they are seeing some stability in their business.

When you look at the automakers at a high level, what do the fundamentals look like to you? How healthy are these companies now?

Whiston: I think it's actually really an exciting time to be an automaker. There is certainly always a lot of volatility and a lot of uncertainty all over the world, but especially when you look at the Detroit Three now, actually, that would be my favorite place to start in terms of health. The Japanese are still also very, very strong, but unfortunately so is the yen, and that's creating a huge problem for Toyota, Honda, and Nissan in particular, but especially Toyota--they are the most exposed to that strong currency impact.

Stipp: So we know some of the automakers have gone through reorganization proceedings, and they have come out seemingly a lot stronger with the better cost structures. Can you talk a little bit about what the profitability is looking like now versus what some of these automakers were seeing in the past?

Whiston: From even just a few years ago, right before Lehman Brothers and the reorganizations and bankruptcy of GM and Chrysler, the profitability picture is just night and day; it's absolutely incredible. And that's why I'm so excited about the future of the Detroit automakers.

Look at GM, right before the recession they broke even with 25% share, and they needed an industry-wide what we call SAAR, or seasonally adjusted annualized selling rate, of 15.5 million vehicles in the United States. Now they only need 18% to 19% share and a SAAR of roughly 10 million units a year.

And 10 million units, by the way, is ridiculously low. Even in '09, which is the bottoming out of this current cycle we're in, we sold 10.4 million vehicles in this country. And just to replace the fleet, you've got to do about 13.2 million vehicles; that's 240 million vehicles on the road times the 5.5% scrappage rate.

So if GM can break even at 10 million vehicles and you need 13.2 million just to even replace the fleet, that's one of the reasons I have been so optimistic about GM printing money. When you look at normalized demand, though, the numbers are even better, because I think it's roughly 16 million to 17 million units a year. 2011 is going to be the fourth consecutive year we're at or below scrappage in the United States, so that trend cannot continue.

Stipp: So I want to talk to you about some of those sales trends, because we have seen improvement, and we've gotten closer to what that average has been, but we haven't hit that yet, correct? What are you looking at for sales for 2011 and sales for 2012? What are your expectations?

Whiston: Well, barring any major severe supply shocks like we've had in Asia twice this year, unfortunately, I think 2012 and 2013 are going to be the years where we're really going to see a lot of positive surprises in the auto industry. And the exciting thing is, I think the absorption of all this pent-up demand, it hasn't really started yet. November was the best month, going back to the SAAR rate, November was the best SAAR in the United States since Cash for Clunkers, and I think that's just the beginning. It was about 13.6 million.

But there is a lot of uncertainty, of course, with Europe, and if in a worst-case scenario, we were to have, say, 10 Lehman Brothers happen in Europe happen at the same time, that's certainly going to impact U.S. consumer confidence, too. So that's the volatility and the uncertainty I alluded to earlier.

Stipp: At some point, though, Dave, don't people have to go out and buy new cars, even if they don't want to. Their cars just wear out, right? Are we are getting to a level of pent-up demand where even if they don't want to put the money up, they might have to start looking for a new car?

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Whiston: Absolutely. The statistics are there; it's just data. The U.S. fleet, for example, is at about its oldest age ever, about 10.7-10.8 years. You can certainly say, "Well, I'll just always buy a used car," but used-car prices are actually sky high right now, because of the very paper-thin supply we have of quality late-model used vehicles in this country. So you can actually get a really great deal now on a new car, sometimes even better than a used car, and that will just cause the whole market to get back in equilibrium, but it's a gradual process.

Overall, if you look at the data over the past four years, if we assume 16 million as normalized demand, and just subtract that from the actual sales every year, and then add up that difference, you are looking at pent-up demand of 16 million units. Mike Jackson, who runs AutoNation, has said, it's at least 10 million units.

Stipp: So, it looks like potentially some brighter days ahead on that front.

We talked a little bit about some of the global uncertainty, and I'd like to get your take on what the global picture looks like for sales for the automakers. So, we talked about some domestic demand. How important are emerging markets to some of these automakers, though? Markets where people maybe haven't even owned a car before?

Whiston: Obviously, tremendous growth all over the world, as more and more third world nations become closer to first world nations, and where consumers want a car instead of a motorcycle or a bike or using their feet, for example. Volume-wise, the growth story is tremendous.

I would not be looking for any major good news out of Europe. It doesn't matter which automaker you are talking about, at least on my coverage list, with GM, Ford, Toyota, Honda. Their key markets are the United States and Japan.

Stipp: So, certainly, sales in the emerging markets, a potential bright spot, but what about profitability? How well do the automakers do in different parts of the world? And how important is that profitability picture to the overall mix of their profitability?

Whiston: That's a great question, because everyone loves to talk about China and loves to talk about emerging markets this, emerging market that. But especially with the Detroit guys, take the time, sometime, as an investor to look at the quarterly earning slides at GM and Ford in particular, where they break out their operating profit contribution by geography. You can see, it's heavily skewed toward North America, which in particular is the United States.

So, the most important driver for GM and Ford in particular, but also Toyota and Honda, is going to be the United States. And that market, as we've talked about, is going to be coming back quite strong over the coming years.

Stipp: So, what's behind that increased profitability? Is it that there are more add-ons and bells and whistles in these cars, and so they have a higher margin, because there are maybe not the bare-bones models you might see in some of the emerging markets?

Whiston: A couple of things going on. Obviously, in the U.S., you have a more attractive sales mix, because you get more light-truck sales, in particular, those full-sized pickup trucks that GM, Ford, and Chrysler sell, are immensely profitable. In fact, one bank recently put out a report that said those vehicles were the most profitable vehicles of the past 20 years. It's not surprising given how much you can sell them for and the profit margins with them.

But also another thing going on in the United States now is that, because of things like a much leaner cost structure through some controversial measures like the bankruptcy, but also because of some concessions made by the UAW, the main union there in Detroit, what's so exciting now is that the Detroit Three can actually make desirable small cars that people really want to buy, rather than because they just want to get something cheap, because it's heavily incentivized. No one has to overproduce anymore. Residual values are skyrocketing because of that, especially for the Detroit guys. If you don't believe me, go to an auto show. Look at a Chevy Cruze, look at a Chevy Sonic, look at a Ford Fusion, look at a Ford Fiesta. These are not like the Chevy Cavalier and the Ford Tempo and the Ford Escort from years ago.

Stipp: So, better cost structure, also better product at the end of the day there.

I want to talk to you a little bit from an investor's perspective. As you are looking across your coverage universe, which companies look well-positioned right now? And then also importantly, what do valuations look like? Are you seeing any valuation opportunities given this brighter picture that you are seeing for a lot of the companies that you cover?

Whiston: I definitely think the automaker space is my most attractive segment of the auto supply chain right now. The auto dealer rally, I think, already happened last year and the year prior, and suppliers--I only cover a couple, Gentex and Johnson Controls--they've been oscillating between 4- and 5-star territory.

But when you look at the automakers, and unfortunately, those that have bought GM right after the IPO, they saw a little bit of a bump up originally, and it's been pretty bad news for GM and Ford's stock price since then. But I'm sticking to my guns here. There's no reason to doubt this turnaround in the United States. It's just going to take time. And when you look at the fundamentals--let's take GM, for example. You've got a company that's been restructured now. Yes, it was controversial, but what's done is done, whether you agree with it or not. General Motors now has just under $11 per share of net cash on its balance sheet. So even on a GAAP basis, let's take a P/E multiple, price to earnings multiple, for next year, it's roughly 5-6 times earnings. If we back out the cash, if we adjust for that cash, GM is only trading at 2.6 times earnings. It's only trading just over about 1 times EBITDA. You are basically getting a tremendous company with an excellent balance sheet and a tremendous amount of upside for nearly nothing, and I think that's a pretty good deal.

Now on the flip side, of course, the government still owns a lot of shares, the union has a stake in it, but the government is not going to own those shares forever. And once they get out, and that will probably, at least the majority stake, it will get out before the election. And once it happens, I think you are going to see GM stock trading a lot higher than the near $20 level that it's at today.

Stipp: What do you think accounts for all that pessimism? Is it just all the global uncertainty and folks are extrapolating that across different industries, and automakers in this case, and it's really keeping those stock prices depressed? Or is there some risk out there that you think people are pricing in that you just don't expect to come to fruition?

Whiston: Well, in GM's case, you've got some extra risk like some ... potential investors don't like the overhang, so to speak, of the union having a stake through the retiree health-care fund. And the Canadian-U.S. government do still own it, and some people say, "You know what, it may be cheap, but I am going to wait for the government to get out before I get in."

But whether you are talking about GM or any other name on my list, one thing that's continued to happen all year is that, the macro uncertainties, and particularly from Europe, and recently we had some fears about a slowing U.S. economy, those fears have really trumped bottom-up fundamental analysis, and of course, as you know, at Morningstar, we are more bottom-up investors.

So, we will look past that; I am not saying you should ignore the macro headlines. What's going on in Europe is extremely serious. But again, look at the fundamentals, look at the balance sheet, look at where U.S. auto sales are going, look at the fact that GM and Ford get most of their earnings from the United States. If you are a patient investor, you are going to be rewarded buying those stocks at these levels, in my opinion.

Stipp: Last thing I want to talk about, Dave, is some of the trends that you've seen in the auto industry, and I know that alternative energy cars have been a big trend. To what extent do you think the battery-operated cars or the alternative fuels will play a role in what the future of the auto industry looks like here in the U.S.?

Whiston: You will certainly see more and more alternative power trains going on, and I think for people who like the technology side of autos, it's very exciting. In particular, though, I would say to people, don't get too hung up on electric vehicles. You are going to see much more improvement and much more popularity from a technology, for example, called start-stop technology coming to the United States. It's much more common in Europe right now. Americans don't really know about it, yet. But it basically means when you get to a red light, the car shuts off automatically, the battery will keep running your AC and your radio, and then you take your foot off the brake to start driving, and the battery automatically restarts the car. So, it's great news for Johnson Controls, by the way, because they are the number one player in these batteries.

But when people look at electric vehicles, I just think outside of some key markets that are more environmentally conscious, such as the West Coast, you've got to look at the data nationally. And nationally, hybrids, for example, are only 2.5% of the entire U.S. new light-vehicle sales every year; that's not a lot. Really the reason is value. Compare a Prius to a Corolla--there is a $6,000-$7,000 difference in their price. Yes, you get some better fuel economy with the Prius, of course. But internal combustion, people are ignoring the great fuel economy improvements that come with internal combustion. Hyundai and Ford each have four models, internal combustion or hybrid, that do 40 miles per gallon. And in electrics, that discrepancy gets even bigger. I have driven a Volt; I loved it. But I would not spend $32,000-$33,000 after a tax credit to buy one, when you can get a Chevy Cruze for $16,500; it just doesn't make sense.

Stipp: All right, Dave. Some great insights. It sounds like definitely automakers are worth a second look by investors. Thanks for joining for me today.

Whiston: Thanks.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.