Will Cash for Clunkers Keep the Auto Industry Rolling?

An optimistic buzz has surrounded the Cash for Clunkers program, which offers consumers up to $4,500 in subsidies to trade in older, more-polluting vehicles for new, fuel efficient models. The mood improved further on Monday after  Ford (F) reported its first sales increase since November 2007. Ford attributed the performance to a combination of incentives for clunker trade-ins and more fuel-efficient models. 

Nearly half of the clunker incentives were used to purchase cars from U.S. automakers, helping ease the year-on-year decline in domestic vehicle sales to 4.2% in July from 13.5% in June. Other auto producers' results were less encouraging: Toyota's sales fell 11.4%, Honda's fell 17%, GM's dropped 19.4%, and Nissan's fell 24.6%.

The House approved an additional $2 billion for the program Friday after unexpected popularity quickly drained the original $1 billion budget, and the Senate passed an extension Thursday night ensuring the voucher scheme will be able to continue through the rest of the summer.

Will Cash for Clunkers Have Lasting Benefits?
According to Morningstar stock analyst David Whiston, "the key question for determining if 'clunkers'-driven sales are beneficial is whether the increase in demand is incremental, or if we are actually pulling 2010 demand into 2009." So far, he says, those car owners trading in clunkers are likely not consumers who would have purchased cars in 2010, but rather would have otherwise driven their cars into the ground if not for the clunkers incentives. So, Cash for Clunkers does seem to be generating sales that would not have occurred otherwise, rather than cannibalizing future sales.

Cash for Clunkers does increase short-term demand, but the program doesn't change the fundamentals necessary to drive long-term demand. Only a limited number of people qualify for the clunkers program, and it will not last indefinitely, even if it is extended. The program also does not address two key issues facing automakers:

1. Unemployment and the fear of becoming unemployed. Consumers still remain hesitant to spend money on cars, and this is the key element hampering sales.

2. Global overcapacity in the auto industry. Excess capacity creates pricing pressure and makes it difficult to earn high economic profits for all participants. Whiston says the industry will have to cope with overcapacity for the foreseeable future.

Still, we believe the environment could be looking up for some automakers. Pent-up demand has been building for a long time, which is evident in the strong performance of auto parts companies, such as  AutoZone (AZO) and  Advance Auto Parts (AAP). Car owners have been buying parts to keep their old cars running, but they can only do that for so long. Per capita car ownership is currently at its lowest level since the 1950s. Whiston thinks we will eventually see an uptick in per capita cars, but it will be based on a true economic recovery versus a short-term incentive like the Cash for Clunkers program.

Under the Hood of the Major Players
Overarching industry dynamics will play a major role in the results for all the car companies, but company-specific traits will position some above others. Here's our quick take on the big players:

 Ford  (F)
Ford has implemented several changes that we think will help it compete better in the U.S. However, it will take a long time for the company to regain market share in the United States, as consumers are still very loyal to Japanese and European brands. We think Ford is seeing significant benefit from avoiding bailout loans provided by the U.S. government. Ford's products, marketing, and new union contract should position it to compete better than in the past. Good products combined with a lack of bailout loans means Americans who want to buy an American brand but are angry about bailout loans have only one choice--Ford.  Click here for the full Analyst Report.

 Toyota (TM)
A weak dollar and plummeting U.S. demand for light vehicles have created a very difficult environment for Toyota. However, although profits will decline this year, the world's largest automaker is one of the best positioned in the industry. Toyota's strength is simple--it makes many types of quality vehicles that people want to buy. Toyota's other strength is its manufacturing expertise. Toyota has struggled with overcapacity, however. Contrary to management's assertion of not laying people off, it's hard to see how Toyota can continue to keep plants open for an extended period if excess capacity cannot be utilized.  Click here for the full Analyst Report.

 Honda (HMC)
A weak dollar and plummeting U.S. demand will also make the future difficult for Honda, but the company's brand, products, and strong financial position will keep it on solid ground.  Unlike the Detroit Big Three, which are only just now focusing more on fuel-efficient cars, Honda's product line is not reactionary and instead comes from management anticipating consumer demand. But despite a strong product lineup, Honda still operates in an industry with formidable threats.  Click here for the full Analyst Report.

 Nissan (NSANY)
Although Nissan is finally on stable ground after its problems in the late 1990s, falling demand for autos and the weak dollar will create difficulties for it as well. Nissan is partnering with NEC to make lithium-ion batteries for an electric car that will be sold in the United States and Japan in late 2010 and the rest of the world by 2012. Expanding into electric vehicles is the right move. However, the weak dollar and poor demand will force management to find more cost reductions as price increases are hard to pass through to consumers.  Click here for the full analyst report.