January 10, 2013
Recently, the auto stocks have been very hot topics as high profile hedge fund managers revealed large bets in GM and Ford. In this article we will investigate market expectations for four of the largest automakers in the world: Ford (F), GM (GM), Honda (HMC), and Toyota (TM). We will look at how each company needs to operate to meet and exceed current market expectations since investors make money owning stocks as expectations improve. And improving expectations are driven most reliably by sustained free cash flow. In this analysis we highlight which company can most easily beat today's expectations, by generating the unexpected free cash flow needed to push its stock higher.
Before we begin our analysis, we want to explain our approach. From our perspective, a stock's price represents one "pile of cash." Meanwhile, the company has a track record of generating another "pile of cash." We look for opportunities where the first pile of cash is much smaller than the second pile of cash. In other words, we are trying to find stocks trading at prices below what is justified by the company's operational track record. We do this in the following way: First, we analyze past performance in order to understand how certain operational metrics have performed on average. Second, we look for situations where a firm's operations have to permanently underperform these metrics, in order to justify today's stock price. Third, we ask what changes are likely to occur in the firm's operations. Operational changes can potentially make current market expectations appear conservative or aggressive. In conclusion, our analysis searches for companies with good track records, or improving operations that are not reflected in today's stock price.
The name of this model is the Hanke-Guttridge discounted cash flow model. One of the most unique aspects of the approach is that it defines capital expenditures as any growth in a company's long term assets. In other words it uses growth in the balance sheet as the measure of capital intensity. Additionally, the model uses a uniform discount rate of 10% for all companies which we believe represents a reasonable opportunity cost for an average investor.
The major companies in the automotive industry have large revenue bases and thin profit margins. As a result, little fluctuations anywhere in the cost structure can have a big impact on free cash flow. This combined with the industry's cyclical sales makes understanding the company's long-term average margin structure critical. A company's ability or inability to generate cash flow over the long-term is frequently not obvious because of the short-term cyclical nature of the business. These fluctuations make it easy to lose sight of what is likely to happen over the longer term.
From a historical perspective, it is the auto company's margins that offer the greatest opportunity for shareholders. This is true for a couple of reasons. First, each of the companies we analyze is surprisingly consistent in terms of capital intensity. Second, because the revenue base is large and the margins are fairly small, any change has a big impact on cash flow. Most of this variance comes from two factors directly linked to economic growth - swings in the overall economy and the continuous battle for market share. From a stock picking perspective, this means it is important to look for ideas where margin improvement can be counted on, while not being priced into the stock.
Moving on to the companies
Below is a side by side comparison of the four companies in question. The table contains each company's 5-year average of the listed components and growth of share price over the past year. Note that these are approximations.
Taken in isolation this analysis leads many to conclude GM is the most attractive investment. Despite growing sales at the fastest rate out of our sample, its EBITDA margin is less than half the others. This means management has a tremendous opportunity. GM has a great product line which is allowing them to take market share and grow sales. Meanwhile, after having undergone a massive restructuring, margins have a long way to go before they are in line with its competition. This should offer tremendous upside to cash flows. So despite being the best performer in the group last year, with its stock rising more than 33%, there could still be a ton of upside. The second most attractive investment is probably Toyota. The company appears to have significant margin upside relative to Ford and Honda. Remember this is the critical variable, so despite having the lowest sales growth, it appears the stock has the second most upside on the list.
Thinking In Terms of the Stock Price
As mentioned previously, our approach utilizes today's stock price as a critical input into our analysis. We do this by using a uniform discounted cash flow model and adjusting the numbers to generate today's stock price. This is a step many investors seem to miss - while the story around the company can be great, it does not immediately follow that the stock price will go higher. In order for that to happen, expectations have to get better than what today's price reflects. If the story is great, management typically has to exceed those great expectations to make the investment profitable.
From this perspective we get a radically different view of the opportunities. Below are tables showing a stock price sensitivity analysis for all four companies, comparing EBITDA margins to revenue growth rates. Note that the highlighted portion of each table represents a range of prices based on average trends, except in the case of GM. The highlighted portion here represents the margins and growth necessary to achieve its current price.
The company that looked the most attractive, GM, appears to reflect much of the anticipated margin improvement. Even with a 7% revenue growth rate (over the last 5 years GM has averaged roughly 10%, but given the industry that seems unsustainable), GM has to operate with EBITDA margins basically equal to the rest of the industry. Putting aside the fact that this has never happened, the stock price already reflects the massive improvements. EBITDA margins have to go from their current levels of 4% to 11%. For investors to make any substantial gains with this stock, management has to do better than that! GM must deliver industry best margins and revenue growth roughly equal to the growth rate of worldwide GDP on average over the next 10 years, just to justify today's price. While this may indeed be possible, it's expected and exceeding these expectations seems be a lot to ask from any management team.
GM - Stock Price $40.49
Honda is a less extreme case of GM. Today's price already reflects the outstanding revenue and margin performance.
Honda - Stock Price $40.73
Moving on to Ford and Toyota, both stocks appear to be discounting margins worse than their past performance justifies.
Ford -- $15.84
Toyota - $120.33
From this perspective, Ford now appears to be the best stock of the bunch. The company's current margin performance could justify a price close to $40. However, that is not the end of the story. How a company redeploys capital and invests in its business is a critical variable in both corporate performance as well as stock performance. Generating cash from sales is one thing, but making the critical investments so the company is in a position to continue it, is another. Practically, here is where the conversation moves from a company's income statement to its balance sheet. We are interested in sustained free cash flow. The only way a company can sustain anything is by making the necessary investments which accumulate on its balance sheet.
Toyota has operated with a much higher capital intensity (and much closer to the industry) with 7% of revenues versus Ford's 4%. It does not seem feasible that Ford maintains its current market share and production levels given this relatively low level of capital expenditures. Armed with this information, if we move CapEx closer to our sample's average (roughly 7%), Ford stock is similar to Honda's and GM's (see the below table).
In a nutshell, for Ford's stock to move higher, its capital intensity has to remain below the competition. In a competitive, and capital intensive business, this seems pretty unlikely.
On the other hand, Toyota appears to be largely ignored. The current stock price is discounting below average margins, and average to high capital intensity. One interpretation of this analysis would be to say the market anticipates most of the companies' EBITDA margins to be in the 11% range, except for Toyota's. This is despite the company having a track record of doing much better (in contrast to GM or F). As a result, it seems reasonable that Toyota keeps pace with expectations for the overall industry, and doing so leads to a higher stock price. In fact, looking at the above table, it is possible the stock doubles from its current value without much change in its margin performance or historical growth trends. As we covered in a previous article, today's market price can be justified with COGS around the five-year average of 80%, despite the fact that Toyota is working closer to 77% level. Additionally, there is no doubt management can operate at these levels because they have done it before.
In conclusion, out of our sample the expectations appear to be the lowest for Toyota, giving the stock the most upside. Said another way, because the expectations are already low, the stock probably has the least downside risk and a lot of upside optionality. As a general rule, we don't forecast price targets. Instead we try to find a group of investments where it is very likely we will be able to get our money back, and let the upside take care of itself. By building a portfolio of stocks with similar characteristics as Toyota, we feel like we minimize the chance for losses, while leaving lots of potential upside. However, these are very large and complicated companies. It is quite possible there are hidden pockets of value that can be revealed by a more forensic accounting analysis. For example, GM is a top holding by a number of sophisticated investors who definitely do their homework. That said, GM needs to operate in a way that it has never been able to before. Should management fall short of those expectations, the price decline from today's levels will likely be large.