By David Whiston, CFA, CPA, CFE
We argued in June 2011 and again last April that U.S. auto sales would be increasing far above levels at those times. This prediction has proved correct, with three straight years of double-digit percentage year-over-year increases since the market bottomed out in 2009. Although the growth rate should slow going forward owing to the challenging arithmetic of growing off a higher base, we remain confident that there is still a long growth runway in U.S. autos thanks to a variety of industry and macroeconomic factors.
The Top-Down Argument: We're Still in the Early Phase of a Recovery
First, we should consider how bad things got in the most recent recession. Sales bottomed out in 2009 at only 10.43 million vehicles after peaking in 2000 at 17.35 million. The last time the United States was near the 2009 trough level was in 1982, at 10.36 million. However, 2009 becomes much worse if one looks at the per capita sales ratio of 0.050 - the lowest point ever, dating back through at least 1951. The ratio was 0.069 in 1982, and the next-lowest ratio after that was all the way back in 1958, at 0.063.
With the recession sales pace worse than in the late 1950s, when the country had 61% fewer drivers on the road, we expected a strong sales recovery over the next few years. In 2009 and 2010, the United States scrapped more vehicles than it sold, which had not happened since World War II. In 2012 sales grew 13.4% from 2011 to 14.49 million vehicles, and we expect volume to remain well above replacement demand, which we estimate at 12.15 million. Looking at our auto sales and total population data, and multiplying the 2012 U.S. population by the average sales per capita for 1951-2012, gives a mean reversion sales total of 16.14 million vehicles. Another proxy of normative demand would be the same multiplication using a more recent per capita sales average. For example, using the per capita average from 1976 to 2012 implies a normative demand of 17.36 million vehicles. Pent-up demand could mean some very strong years are coming for the U.S. auto industry. If one assumes a conservative normal annual demand level of 16.0 million and then adds up the annual difference since 2008 between actual sales and 16.0 million, the pent-up demand number comes to 17.46 million vehicles.
As for 2013, we continue to predict a range of 15.2 million-15.5 million. Although the 7% year-over-year increase we predict - on the high end of our sales expectation of 15.2 million-15.5 million - is a slower growth rate than the 10%-13% annual change seen the past three years, we would much prefer to see volumes continuing to grow off of a larger base at a declining rate than the declines we had in 2008 and 2009. It is important to remember that automakers have a high degree of operating leverage, so even small YoY sales increases can grow earnings materially.
First quarter U.S. industry sales growth supports our thesis. The industry increased 6.4% during first-quarter 2013 and is up 6.9% through April. The seasonally adjusted annualized selling rate, or SAAR, for March was 15.25 million units according to Automotive News and was the fifth consecutive month the SAAR exceeded 15 million. January's and February's SAARs were the highest for those months since 2008 whereas March's SAAR was the best March since 16.08 million in 2007. April's SAAR did fall to 14.91 million but was still an increase from April 2012's 14.10 million. There remain many reasons to buy a new vehicle, such as ultra-low interest rates and a wide variety of desirable products such as the Ford (F) Fusion; additionally, many vehicles remain very old, and used vehicle prices are still near record highs. General Motors (GM) in particular has many new products coming out this year with the long-overdue next-generation full-size pick-ups the most critical from a profit-focused point of view. Gas prices can be a concern with larger vehicles but as we said last April, we feel that Americans are much more tolerant of $4 gas today than they were in 2008. According to the Energy Information Administration (EIA), U.S. gas prices peaked at $4.05 a gallon ($4.33 in real dollars) in June 2008. The "panic point" back then for consumers was a national average of about $3.50 a gallon ($3.77 in real dollars); today we are below that real level with a national average of $3.54 a gallon. Since last July nominal gas prices have been in a range of $3.31-$3.85 a gallon and have recently been moving downward. Gas prices in this range and even somewhat higher give us confidence that fuel concerns will not slow auto sales. Pick-up trucks for example are selling at a rate far above the industry's overall rate.
We think it is also important to understand that internal combustion cars from the Detroit Three are much more fuel efficient than in 2008. Advances in turbocharging technology, design and lighter materials have allowed consumers to have good fuel economy regardless of vehicle segment compared with just a few years ago. This improved fuel economy not only makes Detroit vehicles more competitive with import models but also gives consumers a reason to keep buying cars if fuel prices spike again. We remain very optimistic about the future of U.S. auto demand as macro issues such as Europe and payroll tax hikes do not appear to be materially reducing American consumers' desire to buy vehicles. We think this resilience is because of great product and most significantly due to the fact that the industry fell so far in 2008-09 that it has to keep rising to make up lost sales.
The Bottom-Up Argument: GM's and Ford's Transformations Are Not Complete
GM remains on our Best Ideas list because the stock is trading far below our $52 fair value estimate and is a better company than Old GM. Buyouts, restructurings and establishing the voluntary employee beneficiary association, or VEBA, to transfer retiree healthcare obligations to the UAW have led to a dramatic reduction in costs. Management recently disclosed that from 2007 to 2010 New GM reduced its total North American fixed costs by over 23% relative to Old GM, and since 2010, North American fixed costs, excluding pension income, have been flat at $22 billion a year.
Still, one of GM's biggest problems is not getting enough economies of scale despite being one of the largest automakers in the world. GM is behind Ford by several years in embracing global, or core, vehicle platforms but is moving in the right direction. GM has goals for 2018 of reducing the number of platforms to 14 and increasing volume on core platforms to 95% of total volume from 60% today (and just 31% in 2010). Having one platform for a segment instead of multiple platforms for each region can save billions. Ford plans for its production to be on 14 platforms by 2014 and 99% of its production to be on nine core platforms by 2016. Even though GM is behind Ford in this race for scale, GM still has plenty of efficiencies it can realize and can perhaps surpass Ford's margins thanks to GM's higher volume.
These efficiencies have helped GM lower its break-even point for GMNA to a U.S. industry sales rate of 10 million-11 million units depending on mix. This level is a dramatic reduction compared with third-quarter 2007 (the last time GM broke even prior to 2010) of 15.5 million units. To put that into perspective, the U.S. can go back to sales levels seen during one of the worst-ever recessions (10.4 million units sold in 2009), and GM would either break even or have a very small loss, depending on mix. Old GM lost billions and had to reduce its capital expenditure, which left New GM with the oldest product lineup in the industry. New GM now has a steady capital expenditure level of $8 billion annually, which we think will allow it to remain competitive in any phase of the business cycle.
The Path to 10% Adjusted EBIT Margin in North America
There is still much work to be done, and GM investors will have to remain patient for the turnaround story to unfold. We think GM will be a dramatically better company over the next few years and today provides an opportunity for long-term investors. GMNA adjusted EBIT margins averaged 7.4% for 2010-12, and management is right to say that 10% is a more acceptable level for the industry. The company's plan to reach 10% by roughly mid-decade focuses on revenue improvements, more fixed-cost reductions, and materials/logistics efficiencies.
Great product is the genesis of any additional improvement as it affects so many other areas, such as residual values, borrowing costs and the health of a firm's dealer network. GM's product pipeline suffered as a result of the bankruptcy, in particular with full-size pick-ups and full-size sedans. The current-generation pick-ups and Impala sedan were released in calendar 2006 and 2005, respectively, and both segments will see a new-generation vehicle this year. GM is in the midst of one of its most aggressive product revamps ever, which is causing 2013 to be another transition year, but we think the right investments are being made.
Through calendar 2016, GM will launch product at twice the pace of calendar 2009-12. By 2016, 89% of GMNA volume will be from vehicles new since 2012. The pick-ups are the most important launch but other key launches include the new Impala sedan, which should see a higher price of at least $6,000 per unit, since it will no longer have the vast majority of its volume going to rental fleets; the next-generation Cadillac CTS midsize sedan, which comes out late this year, complementing the new full-size XTS and compact ATS released last year; Buick's Encore small crossover, a new segment for the brand, and new SUVs such as the Chevrolet Tahoe and Cadillac Escalade, which are due in early 2014. Other recent new vehicles have already done well, such as the Chevrolet Cruze compact sedan doubling its segment share to 8% compared with the Cobalt while earning ASPs of $4,000 more per unit.
In addition, the Cadillac ATS has been a big success, with the automotive press awarding it North American Car of the Year at the North American International Auto Show in Detroit, and the vehicle has been very well compared as a formidable competitor to the BMW 3-Series and Mercedes C-Class. We drove the turbo ATS in Detroit this year and were not disappointed. Luxury models earn higher profits than volume models so a stronger Cadillac boosts residual values and GM's margins. We continue to strongly believe that Cadillac needs to announce a rear wheel drive flagship sedan to give Cadillac a direct competitor to the BMW 7-Series, Mercedes S-Class, and Lexus LS. That said, by the end of 2014, all of Cadillac's lineup will be new relative to 2010.
Consumers and dealers also benefit from a better GM product. Great product helps GM continue to close its residual gap on vehicles after three years of ownership. In 2009 GM's gap was 600 basis points relative to the industry but is only 200 basis points today according to the company. This gap however still leads to GM spending as much as $200 million a year to make leasing its vehicles competitive for consumers. More throughput for GM dealers also means more lucrative service business, which in turn makes dealers more willing to spend millions on facility upgrades. Over 90% of GMNA dealers are participating in renovation programs, with 50% of the work to be done this year and 90% by the end of 2014. Great product combined with a leaner cost base and rising industry volumes for several more years in GM's key U.S. market as argued above should be very good news for shareholders.
Management estimates that further overhead reductions and insourcing most of the company's IT will result in $400 million a year of reduction in selling, general, and administrative expenses, or SG&A, which is 2.9% of 2012 automotive SG&A. Manufacturing cost reductions of $500 million a year over the next few years are intended to offset higher pension, depreciation and marketing costs in 2013 to help fixed costs stay at $22 billion. GM has too many skilled trade workers who over time will leave via natural attrition and not be replaced. The labor contract gives GM flexibility to have more Tier II hourly workers than it has today. Finally, on materials and logistics, management expects $1 billion a year in cost reductions from changes such as needing fewer materials to serve so many vehicle platforms as discussed above; bringing in suppliers far earlier than before to get the lowest cost at the start of a vehicle program instead of arguing over small improvements each year; and working with consultants, which have helped GM identify logistical savings from various unspecified freight handling changes. All the improvements discussed will be made without having to add new plants to meet growing demand. The former Saturn plant in Tennessee will reopen per the 2011 labor agreement but other changes to get utilization to 130%, on a two-shift basis, will come from adding shifts, which enables GMNA capacity to reach about 4 million units to serve a 17-million-unit industry run-rate.
Europe and Pension Remain Overhangs But We Think Stock Is Still Cheap
GM Europe GME lost $1.8 billion in 2012 and has not been profitable this century. The expectations cannot be great when management's own forecast is to just break even by roughly mid-decade. The positives for investors are that GME finally has a permanent leader in place after the March 1 hiring of Dr. Karl-Thomas Neumann. Dr. Neumann comes to GM from Volkswagen where he was head of VW China. In late March, all Opel factories in Germany except Bochum accepted the amended labor agreement, which freezes wages through 2015 in exchange for job security. On April 10, GM held its board meeting in Germany as a show of support for Opel remaining a key part of GM's future. Management also announced plans to invest EUR 4 billion in Europe through 2016. GME will have 23 new or refreshed models released through 2016 along with 13 new powertrains.
Still, EU27 auto registrations continue to fall. 2013 is not yet showing the signs of bottoming out that some pundits had expected. In January we expected EU27 registrations to fall 6%-10% this year relative to 2012, and so far this has proved accurate, with registrations down 9.8% through March. In fact, the region had its worst February (down 10.5% from Feb. 2012) since ACEA began collecting data in 1990. Key markets such as Germany, France, Spain and Italy are down 12.9%, 14.6%, 11.5% and 13.0%, respectively, in the first quarter. The U.K. remains the only bright spot, with registrations up 7.4% in the quarter. The key for GM for now is to reduce losses via more new and great product, such as the oversubscribed Opel Mokka crossover, and to continue to reduce costs throughout the rest of the world, as discussed above, while the key U.S. and China markets continue to contribute strong profits. GM's narrowing of its European loss in first quarter to $175 million from $294 million in 1Q 2012 is a great start but much more needs to be done.
Capital Allocation Improving, and More Changes Could Come in 2014
GM finally bought back some shares in December with the 200-million-share repurchase of part of the U.S. Treasury's 500-million-share stake. We calculate that the Treasury owns about 13.8% of GM stock on a diluted basis while the Canadian government still owns about 7.6%. The Canadians have not announced an exit plan for their 140-million-share stake, while the Treasury expects to be out of its GM investment by the early part of next year. We suspect the Canadians will exit once the Americans are out, to end public ownership of a high-profile private enterprise. We think the Canadians also are hoping that GM's stock increases as the Americans exit and then they can sell at a higher price to minimize Canadian taxpayer losses. We would certainly welcome further buybacks by GM management on the open market but it is possible GM will choose not to use its $27.4 billion cash hoard for more repurchases when it just bought back Treasury shares.
Given that management seems unwilling to make large discretionary pension contributions at this time, we want to see further action sooner rather than later to return funds to shareholders. After pension funding, buybacks would be our next choice, but we now would not be adverse to GM initiating a common stock dividend. The argument for doing so would be that GM has plenty of cash on hand, we suspect the board is envious of Ford resuming and then doubling its dividend to a current nearly 3% yield, and most important, a common dividend would open GM's stock to a new institutional shareholder base. We calculate that to match Ford's yield, GM would have to pay an annual dividend of about $0.90 a share based on the actual shares outstanding of 1.374 billion, which would cost the company about $1.2 billion - a manageable figure in our opinion.
The argument against paying a common dividend is that GM already pays dividends to its Series A and B preferred shareholders. The Series A shares pay a very expensive 9% and are mostly owned by the VEBA with a small stake owned by the Canadian government. GM sold the Series B as part of the IPO, and these shares pay a 4.75% dividend but mandatorily convert to common stock on Dec. 1, 2013. Dividends paid on both classes total about $859 million a year. We expect GM to redeem the Series A in full when it is first allowed to on Dec. 31, 2014, so it is likely there will be little to no common dividend until after this redemption. The redemption if done all at once would cost $6.9 billion. This large of a cash outlay is certainly reason enough for management to delay paying a common dividend.
Even without a common dividend we argue there is plenty to like in the GM turnaround story despite Europe and the pension. In the recent past Ford was criticized for disappointing quarterly results but said it was investing now for future revenue. Ford then delivered with outstanding North American margin expansion of 210 basis points in 2012 versus 2011. We see no reason why history cannot repeat itself as GM becomes a much more efficient global company. Furthermore, we would expect P/E multiple expansion should interest rates rise enough to materially lower the pension obligation but not enough to stifle consumer purchasing power. This scenario playing out at the same time the U.S. market is in a long growth phase, as we argued earlier, should mean tremendous upside to GM's stock. We said at the IPO that New GM would be printing money and we still believe that today.
Ford's Stock Also a Great Value and Not Fully Appreciated by Investors
We continue to see upside to Ford's stock with a fair value estimate of $21. The company's North American operations are currently performing at what we consider an outstanding level for an automaker. Management reduced North American structural costs by $8.5 billion since 2005 and better produces to match demand, which enables stronger contribution from pricing than in the pre-Alan Mulally days. Ford is also ahead of GM in its adoption of global vehicle platforms, enabling Ford, by our math, to generate about $3,000 of profit per North American unit sold compared with about $2,300 at GM. Ford's 2012 North American pretax profit increased 34% compared with 2011 to $8.3 billion, while margins came in at 10.4% versus 8.3%.
We see more economies of scale coming to Ford and more margin expansion as the cost structure becomes more efficient at the same time that the key U.S. market grows. Ford will have 99% of its volume on nine platforms (five global and four regional) by 2016 compared with 14 platforms by next year and 27 in 2007. Ford used to be run as a silo operation by region, so, for example, North America, Europe and Asia would each have its own compact car platform. Ford wasted hundreds of millions, if not billions, of dollars every year doing separate design and R&D work on each region's vehicle. The new One Ford plan means one global compact platform that will eventually support over 2 million annual units (instead of several hundred thousand per region) and 11 Ford-brand top-hats including the Focus (the world's top-selling nameplate), C-MAX dedicated hybrid, and Escape/Kuga small crossover. These same efficiencies will expand on existing global platforms such as subcompact B, midsize CD, compact pick-up, and commercial van segments.
Ford Gaining Share in the Critical "Super Segment"
The super segment is a Ford term encompassing four segments: subcompact car, compact car, midsize sedan and small crossover. The applicable Ford brand vehicles, respectively, are Fiesta, Focus, Fusion and Escape. These four segments count for slightly more than 50% of U.S. new vehicle sales and according to Ford made up 35% of the market back in 2004. In the first two months of 2013, the blue oval brand's share of the super segment reached a record 12.7%, more than double its share in 2005. Great new product such as the new-generation Fusion and Escape explain Ford's success in this area. We have long been fans of the Fusion, with its Aston Martin-inspired grille bringing exciting design to a normally bland segment dominated by the Toyota Camry.
Sales data shows Ford increasing its super segment share by 40 basis points from first-quarter 2012 while both Toyota (TM) and Honda's (HMC) super segment vehicles lost share. We think it is also encouraging for Ford that in the first quarter the Fusion and Escape (which are the most cross-shopped vehicles within Ford) combined have outsold the Toyota Camry and RAV4 by 11,298 units and are nearly even with the Honda Accord and CR-V. Escape is even leading its segment by passing CR-V. Fusion gained 40 basis points of industry share in the first quarter and is selling very strongly, which gives credence to our long-standing opinion that Detroit can now make cars to compete with the Japanese.
Capital Allocation Likely Focused on Dividend Over Buybacks
Bad times forced Ford to stop paying its dividend after July 2006 but the company reinstated its dividend in first quarter 2012 and doubled it to $0.10/quarter starting this year for nearly a 3% yield. We believe the dividend is quite safe given Ford's cost-cutting efforts, the growth ahead for U.S. autos, and because we do not think the board would resume the dividend unless it was confident Ford could pay it in nearly any type of macroeconomic environment. We think Ford should continue to pay its dividend and normally we would like to see buybacks when the stock is trading well below our fair value estimate as it is today. However, we are encouraged to see Ford making large discretionary pension contributions and think for now this funding is a better use of cash than buybacks would be. Ford's global pension plans finished 2012 at about 77% funded (79% in 2011) with a deficit of $18.7 billion, or $4.66 per diluted share. This amount is obviously a very large liability and a very large overhang on the stock in our opinion, so management's plan of $5 billion of funding this year should greatly help - especially when interest rates rise. Ford does not expect to have any legal obligation to fund its U.S. plans in 2013. Our own discussions with management indicate Ford's investor base prefers a dividend to buybacks so we are not expecting share repurchases in the near to midterm.
Another use of cash in the next few years will be to bring automotive debt down to about $10 billion by mid-decade per management's forecast. Ford finished 2012 with $14.3 billion of automotive debt, including $5.6 billion of loans from the U.S. Department of Energy for advanced technology vehicles. The DOE loans are payable through June 2022 and carry interest at a weighted average rate of just 2.3%. In January, Ford Automotive issued $2 billion of 30-year notes and used $593 million to redeem 7.5% 2043 callable notes; and the rest of the funds went to the pension. These actions make the automotive debt balance equal to $16 billion at March 31. We do not expect the DOE loans to be prepaid in full given their low rate. Management's comments on a recent fixed-income analyst call suggest much of the debt reduction to about $10 billion will come from amortization of the DOE loans, maturation of $729 million of European Investment Bank loans due in third-quarter 2015, and $908 million of convertible notes becoming callable in 2014. We estimate that these actions would bring automotive debt down to about $10.8 billion by the end of 2015, all else constant.