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Stock Strategist Industry Reports

China's Weakness Doesn't Faze European Auto Outlook

Morningstar's Rich Hilgert has already factored in lower demand, and his valuations are unchanged.

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We expect low-single-digit percentage declines in Chinese automobile demand for 2015 and 2016. Our long-term thesis on the growth potential of vehicle sales remains intact. We forecast annualized China sales growth in the mid-single-digit range, and as a result, our fair value estimates for the European automaker stocks are unchanged.

China law prohibits foreign auto manufacturers from operating in the country without an indigenous partner, with ownership of operations by foreign automobile companies limited to no more than 50%. As a result, weak Chinese auto demand and currency devaluation will sideswipe near-term profits for European automakers with regard to joint venture equity income.

Consensus earnings estimates are decreasing with weaker China auto demand and, along with the yuan devaluation, are likely to bring down consensus price targets. Our fair value estimate system is a long-term one, as opposed to the near-term trading perspective of some other analysts' price targets. Given this, it may be worth taking price weakness as an opportunity to purchase shares if they reach a 4- or 5-star rating. We suggest that investors pay close attention to  Fiat Chrysler (FCAU), which we see as one of our best investment ideas, as the market typically discounts the stock--and its underlying assets--excessively because of incredulity regarding potential for future profitability and cash flow.

We have cut our 2015 growth forecast for China auto demand from 7% and now forecast it to be somewhere between flat and a 3% decline. Through the first seven months of the year, China is up 3% compared with the same period last year. However, for the month of July, total vehicle sales volume dropped 7% versus the prior year. We think year-over-year comparisons will get worse before they get better, remaining negative through the first six months of 2016. As a result, we forecast another flat to 3% decline for 2016, compared with our 2015 estimate.

Fiat Chrysler Has Least Exposure to Damped Demand
In general, Chinese consumers have been postponing new vehicle purchases, as pricing has been in decline. Why buy now when the same vehicle may be cheaper next week?  Volkswagen (VLKAY) has the greatest exposure to the worst-performing segments of the Chinese market. Car volume is down due to a shift in demand toward sport utility vehicles, while the luxury segment has suffered from government scrutiny of graft, which manifested in some party members' conspicuous spending. Fiat Chrysler has the least amount of exposure. Its Ferrari nameplate does have significant exposure, but we expect less impact on exotic demand, which is driven by ultra-high-net-worth individuals.

European automakers' profitability will be negatively affected by softening in China vehicle demand this year and possibly next. However, we have been more skeptical than the market of the growth in automakers' joint venture equity income from China. As a result, we had already assumed low-single-digit growth rates for China joint venture equity income in our discounted cash flow models.

Demand for new passenger vehicles has a long growth runway in China. The deceleration currently in the market relates to softening economic growth, the government crackdown on graft and conspicuous spending by party members, consumers postponing purchases with the hope of lower pricing in the future, and the caps in place on annual registrations in certain large coastal cities.

Pricing in the Chinese market has deteriorated and will remain a concern through at least the end of the year. We have long held the position that overcapacity in the global automotive industry is a potential threat to returns, as is reflected in our negative moat trend ratings on all the stocks in this sector. China's move to devalue its currency exacerbates the profit impact of unfavorable pricing.

We expect the growth in personal income in China to spur consumption, including demand for new passenger vehicles. Consumers' growing monthly budgets are creating a vacuum, and nature abhors a vacuum. With the advent of increased disposable income, we expect higher household consumption, including greater passenger vehicle penetration, among China's burgeoning middle class.

While most of the past decade's growth has taken place in China's coastal regions, we anticipate a higher growth rate in personal income, and hence consumption, in inland provinces. SUVs will remain one of the fastest-growing segments, as consumers value the enhanced driving experience and roomy interiors. In rural areas where road conditions are underdeveloped and in various states of disrepair, SUVs are more popular. Growth in per capita disposable income has been strong in urban regions, but the rate of increase in rural areas has been even stronger, spurring rural consumers' SUV purchases.

Richard Hilgert does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.