Will This Major Catalyst Boost This Space And Quiet The Critics?

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 |  Includes: F, GM
by: Brian Nichols

A very good read from the weekend entitled Open All Night: America's Car Factories", by the Wall Street Journal will give you a look at the operations of the auto industry relative to its past. The piece looks directly at capacity utilization for U.S. auto makers, suggesting that this capacity may be reaching its limit. While I disagree with the article, it rings a familiar bell that we have heard in recent weeks regarding the auto industry. After both General Motors (NYSE:GM) and Ford (NYSE:F) have rallied with strong one-year performances, it makes sense that concerns would come to surface. With that said, are these concerns appropriate; are they more based on price rather than valuation, and is there a near-term catalyst that could catapult the space higher?

Is Capacity Reaching Its Limit?

Seeking Alpha's market current led me to the WSJ piece; the current did a good job at providing a run-down for the article's main discussion points. These main points are as followed:

  • Capacity utilization is at an all-time high
  • ~40% of North American car factories produce vehicles 80 hours per week, compared to 11% five years ago.
  • 647,600 auto workers today vs. 925,700 in 2005
  • New factories and plants will have to be built, increasing costs.

Two weeks ago, Ford disclosed that building new plants is unlikely. Therefore, as investors, we naturally try to determine a meaning behind such a move, such as slowing growth or concerns of future weakness.

Personally, I look at the direction of U.S. auto manufacturers and can't help but to feel satisfied. First off, if new union agreements allow for working shifts and nights or weekends, then why wouldn't companies take advantage? The WSJ notes that only 11% of factories were producing vehicles at 80 hours a week back in 2007. However, we saw the large financial burden that high costs and limited demand put on the industry during the recession. By producing the most revenue per facility, auto manufacturers are protecting themselves in the event of another economic catastrophe.

Essentially, good companies learn from the past, and use experiences to become better and more efficient. After GM's bankruptcy, and Ford's near bankruptcy, the decision to operate with more capacity seems responsible. Moreover, a ~40% production per 80hr rate should be viewed as a positive, as it shows that there is still a significant amount of room to increase production (more than double current production at 80 hours in other facilities).

A String Of Recent Concerns

This last weekend's WSJ article appears to be yet another cautionary look at the auto market. Right now, it does appear as though there is a lot of pessimism building for GM and Ford. In the last month there has been an excessive amount of concerning outlooks. Here are just a few:

  • News that the U.S. "might" end a 50-year tariff on pickup trucks. If so, this would lower the cost of foreign made pickups, most notably affecting Ford trucks.
  • Auto sales in Russia have declined from last year's record pace
  • Concerns of economic downturn in China
  • Continued pricing pressure in Europe
  • Detroit bankruptcy and its feared implications
  • Of course, the latest U.S. manufacturing concerns

Yes, there are concerns that China's growth could slow, and that rising rates could follow Detroit's bankruptcy. However, most of these noted industry concerns are what you see from a momentum industry, not a value space. In fact, several analysts have even cut their price targets or rating on the auto industry, most notably RBC and Goldman on Ford, citing valuation as the driver. The problem is that despite large one-year gains, the auto industry remains one of the most undervalued industries in the entire market.

An Undervalued Market

So far, in the month of August, GM and Ford have lost 5.5% and 4.5% of their value, respectively. Yet, for the month of July, auto sales rose double digits year-over-year, including a 16.3% gain for GM and an 11% boost for Ford, including a 71% gain in China. Moreover, a report on CNBC showed that the average age for vehicles (on the road) has risen to an all-time high, meaning there is plenty of potential demand. Lastly, let's not forget the incredible quarterly performances from both companies, where losses in Europe narrowed, and revenue grew significantly faster than GDP.

With all things considered, an excessive valuation could lead to a bearish outlook, but all-in-all, we're talking about a true strength in the U.S. economy. Over the last year, GM has traded with gains of 56%, and Ford has gained 70% in the same period. The S&P 500 has traded higher by 16.75%, which might explain the number of valuation-related calls.

While we can look at the one-year performance of both stocks and conclude that both have reached a short-term peak, I think it is important to look back further at stock performance. For example, since January 2011, Ford has traded with a loss of 2.8%, GM has a loss of 6.5%, while the S&P 500 has a gain of nearly 32%. Therefore, the auto industry has not, in any way, outperformed the broader market. In fact, it is a significant laggard.

Ford and GM's lack of stock performance also reflects their valuation. Ford trades at just 9.3 times next year's earnings, and 0.45 times sales. GM trades with a forward P/E ratio of 7.5, and 0.31 times its sales. Compared to the S&P 500's 13 times next year's earnings and 1.5 times sales, you can see that this is a very cheap industry.

Is It Time To Buy

Unfortunately, just because an industry or stock is cheap, doesn't mean that the stock will rise. Sometimes, you can be right with your analysis, but the stock performance will prove you wrong. A good example is with Bill Ackman, and his Herbalife (NYSE:HLF) call. In my opinion, his call was the best I had ever seen, as he broke down the entire company in a way to where no money manager, analyst, or the company itself could defend all of his points. He was simply right, or at least in my opinion. Yet, strong backings of big-name financial juggernauts such as Carl Icahn have proved Ackman wrong, at least temporarily.

While this could be the case for Ford and GM, due to the number of concerns, I find it highly unlikely. For one, fundamentals are expected to rise, and both companies remain very cheap relative to the overall market. But more importantly is the catalyst surrounding dividends. Ford Motor already pays a 2.5% yield, but various executives have discussed raising their dividend further in the near future. While I may be wrong, I think Ford's future dividend hike could work in tandem with perhaps the biggest catalyst for the industry since the recession, involving GM.

For the month of July, The Treasury Department reportedly sold $877 million worth of GM's stock, making the Treasury's recoup about $35 billion of the $51 billion that it gave to GM during the recession. As we all know, GM's largest shareholder had been the U.S. government (since the recession). However, with a plan to be fully divested within 4-5 months, a whole slew of catalyst are expected to occur, including dividend payouts from GM.

Seeing as how the auto industry as a whole trades as a unit, it makes sense that Ford and GM would be valued below the S&P 500, having underperformed the market over the last couple years. GM has a massive owner of its stock that has continuously sold shares. In fact, $877 million worth of stock would equal 25 million shares at $35 per share, or two full days of nothing but selling. Once this activity ends, and if GM implements an immediate dividend, this will remove a significant overhang from the industry, and make an investment much more attractive.

With that said, I think GM is looking most attractive - although I have been a long-term Ford bull - as the stock is cheaper on a price/sales and P/E ratio basis, and has the most to gain with a dividend and a divestment from the government. However, I think the Treasury's divestment will boost the overall space, as it should give investors a sense of security. Therefore, I believe GM, or Ford, is a necessity within the portfolio of any investor. This pair of stocks is simply too cheap, growing too fast, and with a major near-term catalyst around the corner. Hence, I see virtually zero risk in this space.

Disclosure: I am long GM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.