Cyclical companies are supposed to sell at low earnings multiple when they are at their microeconomic peaks. Since General Motors (GM) currently trades around 8.7x 2013 estimated earnings, market participants are therefore telling us that earnings are nearing a peak. Jeffery Saut, recently, wrote about the widespread pessimism amongst investors while the market reached an all-time high. Many investors are indeed skeptical of further growth, as our current economic expansion enters the fourth year. Among many things, they do not believe our unabated appetite for automobiles can continue to grow; and this, in part, has created a great opportunity to invest in a low risk and, potentially, high return investment.
People purchase automobiles for a few major reasons. The primary reason is for transport. It is generally the most cost effective or time efficient way to get to work. For most in our country, you either get an automobile or you have a hard time commuting to work. Cars are also a status symbol. It shows off our economic success, and raises our value to potential mates. In my opinion, these two factors - hunger and hormones - create much of the financial and psychological need to buy a car. There are other factors too! For example, it is also just awesome to roar down an empty highway in a sleek sports car, during the middle of the night, blasting music, and watching the world flash by.
In the grand scheme of things, auto demand is basically driven by two things - replacement demand and new household demand. At the moment, there are roughly two cars per household. As the population increases and jobs are created, new households are created. If job growth is weak, household formations can be deferred. But ultimately, hormones kick in. As a country, we have approximately two hundred and fifty million automobiles and around one hundred and fifteen million families (over 2 per family). Current projections call for over one million net household formations per year.
If you take the historic patterns and projections discussed above as assumptions, you can begin to create an estimate for annual auto demand in the US. The one million or so new net households will require over two million autos per year. To calculate replacement demand, we have to estimate the useful life of a car. If cars last for fifteen years on average, the established households will need to purchase 16.65M cars a year. If cars last for twenty years, they will need 12.5M cars a year (250M x 5%). Combining the two gets us an estimated normalized demand of 14.5M to 18.65M cars per year. At the moment, we have just arrived at the bottom of this range. But due to depressed household formations in the past, there is also pent up demand. If we get a boom, people may buy new cars earlier than expected. I believe we can exceed 14.5M normalized, or even 18.65M normalized annual demand. It is amazing that Mr. Market is giving away a company for peak market multiples, when it has only at the bottom range of normalized demand. Three drivers - a less conservative useful life assumption, pent up demand, and an economic boom - can accelerate sales beyond current levels. But according to Mr. Market, these scenarios are just not possible.
The United States is only half the story, and a poorly performing one in the last few years. Since 2004, GM has been hit by a combination of North American market share losses, a 2M-unit decrease in annualized car sales, and the loss of the old GM Financial (Ally). Although North American automotive sales have plummeted from $150B to $95B & GM Financial sales have fallen from $32B to $2B, overall GM sales have only fallen from $193.5B to $152B (2004 to 2012). GM NA automotive sales declines have largely been offset by some crazy growth in GM's international business.
Autos per 1,000 people
South Korea (Repub of Korea)
The international business still has a major secular tailwind. There is a huge growth opportunity for GM in the emerging market countries. As income grows in these markets, the gap in autos per capita compared to developing countries should decline. In the past decade, the international auto market has grown at a double-digit growth rate per annum. The remaining gap supports continued secular tailwind for many years to come. As the BRIC and the Next Eleven countries see increased income per capita, some of them will double their autos per capita, others will triple or quadruple, and some may even increase their autos per capita by even larger multiples.
The growth opportunities are not limited to selling a greater volume of autos. GM has been rebuilding its captive automotive financing division, since it went bankrupt. The reorganized GM acquired AmeriCredit, a premier subprime auto-lending specialist, with a strong track record utilizing structured credit to finance their lending. AmeriCredit was run by capable executives who expanded their lending during tough times and cut back when the markets became frothy. Since New GM Financial is still run by AmeriCredit alumni, I am comfortable with their continued management of this division and believe in the success of their expansion plans. I believe they will be prudently managed, and their efforts will richly reward shareholders. GM Financial recently built up the ability to finance up to 80% of GM global sales volume. But GM will probably continue taking only the choicest loans for their financial division. They will continue using third party lenders, such as Wells Fargo (WFC) to make the bulk of their loans. As a result of these practices, the vintage of loans made by GM Financial in the last three calendar years, have never been stronger in the past decade. There is not much stopping this accomplished and conservative team, from attaining levels of profitability that would be comparable to Ford (F) or Toyota (TM).
The GM story is much more complex than the thoughts I have shared with you. But overall, I believe this piece has captured some of the economic tailwind and the GM financial story, which I believe, is generally overlooked. There are multiple other factors at play, such as making better cars, which can help GM deliver strong revenue growth and profit growth. But I will save those other factors for later pieces. Please follow me if you would like to read more of my thoughts.