Signs of Life in the Auto Sector: Positive Indicators for Cleaner Internal Combustion Technologies

Although the writing has been on the wall for some time now regarding Obama's willingness to move aggressively on the environment file, few expected his first substantive move to have to do with vehicle fuel economy. On Monday, the President requested that the EPA reassess its earlier decision (taken when the Bush administration was still in power) to deny California the right to set and enforce its own fuel economy and car emissions standards above and beyond those set at the federal level.

Not only are California's standards much tougher than the current federal ones (the state is seeking 42.5 miles per gallon by 2020 vs. 35 at the Federal level, a nearly 22% difference), but 16 other states plan on eventually following suit, together accounting for at least 50% of all cars sold in the US. Unsurprisingly, the auto industry, which is currently contending with a complete collapse in demand, isn't impressed.

While this move might seem counterproductive at a time when the government is expending vast sums of money trying to salvage domestic car companies, it is actually very much in line with two of Obama's defining features - namely that (1) he is concerned with weaning the US off foreign oil and tackling climate change and (2) he believes that regulation can be a force for good. How does the latter point work? Let's go through the main arguments.

First, take the dramatic increase in gasoline prices that occurred over the past few years. There is no doubt that the scale and rate of the rise in energy costs, which far outpaced workers' ability to obtain matching wage increases, left many households feeling significantly poorer, potentially having acted as one of the triggers to this recession. Petroleum accounted for about 39% of primary energy consumption in the US in 2007, the single largest category. A serious push toward raising fuel efficiency can be thus be seen as a means of lessening the blow from a sudden and sustained rise in petroleum costs, something that will almost certainly happen again.

A related argument in favor of fuel economy regulation looks not so much at the negative wealth effect of expensive oil, but rather at the massive transfer of wealth from North American households to potentially hostile countries that occurs under such a scenario (the US imports about $5.7 billion worth of oil each week). Sure, imposing standards that are ahead of what industry can meet given its current technological capabilities and operational configuration (a claim that is questionable if not spurious, at least on the technological capabilities front) creates a transfer of wealth, except this time the money flows to companies that are overwhelmingly not based in hostile nations and that often pay taxes here. In an environment where expensive oil is likely to become the norm, the wealth transfer will occur one way or another - it's about deciding where the money flows to.

Lastly, there is the view that regulation can have positive economic impacts by encouraging innovation and spurring job creation. The German Renewable Energy Law is an example. By mandating outcomes rather than means, government lets the market choose the most efficiency path to get there. Under a best-case scenario, the innovations made along the way become commercial and export success stories. After all, the global trend toward greater fuel efficiency will intensify in the years ahead, and a continuation of the US government's complete aversion toward raising fuel economy standards (helped of course by a healthy dose of whining from Detroit every time the topic comes up for debate) would play right in the hands of the Big Three's competitors.

While the arguments presented above will sound preposterous to many individuals, investors with an interest in alternative energy need to understand that this is in fact the stance that will prevail in Washington for at least the next four years. It will feel a little strange at first given how out-of-favor this worldview has been over the past eight years, but soon people will realize that this is the norm rather than the exception, and that interesting opportunities are emerging as a result. It is therefore important to start looking beyond the current bailout package toward where the Obama administration will go on the regulatory front when the storm has passed. In my view, Monday's announcement provides a good prelude, and tougher fuel economy targets could be on their way at the federal level before too long.

Fuel Efficiency & Emissions Control

There are two main ways to control car emissions and increase fuel economy: (1) make incremental improvements to existing technologies (e.g. more efficient internal combustion engines, catalytic converters, use of lighter alloys and composites in car bodies, etc.) and (2) boost the deployment of disruptive technologies such as natural gas powered cars, hybrids, plug-in hybrids and electric vehicles. While #2 will offer the most significant growth opportunities in the mid and long terms, #1 will play a key 'bridge' role and will continue to receive much focus. What's more, established companies, which tend to dominate #1, provide in theory safer investments in the current environment where investor appetite for risk has all but disappeared.

Given the discussion above, I thought I would revisit four auto parts stocks we have discussed in the past and that are direct plays on fuel economy and reduced car emissions (they all belong to #1 rather than #2). The auto parts sector has been experiencing significant difficulties of late on the back of what may turn out to be the worst slump in the history of this sector. Parts makers stocks are thus down and out these days, and I wanted to see if these four clean technology leaders might offer interesting opportunities. If they can make it through these difficult times, they will most certainly benefit from the new regulatory era that's now upon us.

Company	Ticker	12-Mo. Return (%)	Debt-to-Capital	Current Ratio	Cash Ratio
Magna International	MGA	-4.9	0.07	1.56	0.43
BorgWarner	BWA	-16.4	0.26	1.19	0.10
Valeo	VLEEY.PK	-67.6	0.45	1.06	0.24
Linamar	LIMAF.PK	-49.4	0.35	1.62	0.12
All figures for Q3 2008 except for Valeo which is Q2 2008

I decided to look specifically at three balance sheet items that are good indicators of a company's ability to weather a period that could be marked by significant reductions in sales, margin squeezes as utilization rates fall, and an overall reduction in operating cash. What I found was broadly in line with my expectations: Magna has the cleanest-looking balance sheet and is thus in a strong position to deal with a cyclical decline in sales.

Not only is the firm virtually debtless, but it's got sufficient short-term assets to comfortably meet its short term liabilities (although the cushion isn't huge). What's more, Magna has a comparatively good cash position. Compare it to Linamar, for instance, that has a higher current ratio but the second worst cash ratio. That's because much of its working capital is tied up in inventories and receivables. In the current environment, inventories will be challenging to liquidate and receivables may be difficult to collect as suppliers go under.

Of course, none of this has been lost on the market, and that's why Magna is trading at a healthy 13.4x TTM EPS, versus 4.13x for Valeo and 3.02x for Linamar. However, it remains cheaper than BorgWarner at 18.77x. Both Magna and BorgWarner are in a strong position to benefit from the new regulation, but I can't help feeling a tad uncomfortable with the latter's PE in an environment fraught with so much uncertainty and where economic forecasters have been missing the mark so frequently.

Lastly, Magna and Ford's (F) commitment to bringing a fully electric, battery-powered car to market within about two years is pretty exciting. If the firms can execute on this plan, it would mean that Magna would be a dominant force in #1 (evolution) and #2 (revolution), something that companies in any industry typically struggle to achieve.

Conclusion

The swiftness with which Obama moved on the fuel economy file is, in my view, the clearest indication yet that we have entered a new regulatory era, especially where the environment is concerned. This era will be defined by a belief that regulation can be a force for good, and regulation will thus be designed in a way to encourage innovation. This, in turn, will create plenty of investment opportunities in the alternative energy and cleantech spaces. While there's ample focus on the stimulus package and what green industries will benefit as a result, investors should keep a close eye on the auto sector when we emerge from this recession as that is likely to be a prime target of this administration.

Disclosure: Charles Morand does not have a position in any of the securities discussed above.

Comments

[the weakono...:]

Lighter composites means carbon fiber, which is resource intensive to produce and difficult to recycle. Hardly green. It's just like the hybrid buys who ignore how much goes into making those batteries of theirs.

The problem here is more about letting states set their own regulations. I wrote about this Friday morning as well:
weakonomics.com/2009/0.../

That being said, the prospect of investing in part suppliers appears lucrative. There will be plenty of money spent developing new materials and technologies, and the government has pledged money to help as well.

Could this bring home American manufactoring? We'll see.

Jan 30 03:54 PM

[The Proclaimer:]

Hey Weakon, resource intensive carbon fibers? Not any more! and maybe on both counts. Soon my friend, soon.

Jan 30 08:06 PM

[Tradememe:]

Agreed. Had these new regulations been in place years back, the car industry would not have been in this state today.

Jan 30 10:45 PM

[the weakono...:]

Producing carbon fiber is a resource intensive process. I don't need to tell people here that hybrid batteries are very resource intensive to produce.

Carbon fiber has been around for 50 years, and they still haven't figured out how to mass produce it cheaply. I'm a car guy so I'm all for the use of the stuff. But I'm a car guy, so I'm skeptical about the potential for success.

Jan 30 11:57 PM

[BlueOkie:]

You have car A gets 40 MPG and car B gets 20 MPG. If you drive 20,000 miles a year you save 1,000 gallons of gas. At $4 a gallon, you save $4,000.
If car A is $10,000 more then you need to drive 2 1/2 years to break even.
If you only drive 10,000 miles a year or gas stays under $2 then you need to own the car for 5 years to break even.

Jan 31 09:20 AM

[Dave Wrixon:]

Unfortunately, most of the dividend from the policy will be remitted to Tokyo.

The Japanese did the investment, the R&D and product development. They are now ready to cash in big time.

Unless US Government is prepared to pay about 3x the going rate for this technology, corporate US will be left standing out in the cold.

Feb 01 02:35 AM