Ford And GM Are Pricing In Recession

Feb. 5.14 | About: General Motors (GM)

During this recent market pullback, shares of US auto companies have been absolutely hammered. As the following chart shows over the past three weeks, General Motors (NYSE:GM) has dropped 9% while Ford (NYSE:F) has fallen 11%. Needless to say, that's a pretty painful fall for even long-term investors. As a consequence of this drop, both companies are now lower than they were six months ago. While I am not one to predict near-term bottoms, the prices of these stocks have diverged significantly from their fundamentals. After a great 2013, the S&P 500 could certainly drop another 5% in this correction, and F and GM would likely follow suit. However, longer-term investors looking to buy great companies at discounts to fair value would be wise to buy F and GM on this drop.

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Simply put, Ford and General Motors are trading at extremely inexpensive valuations. In 2014, GM should earn $4.05-$4.45 (analysts are looking for $4.16). With these estimates, GM is trading at 8.5x 2014 earnings. Ford's earnings picture is a bit more cloudy because the company is launching 23 products, which will push some sales back into 2015, depressing this year's numbers. Analysts are looking for about $1.45. I am looking for at least $1.50 with the potential to reach $1.60 while 2015 earnings will exceed $2.00. Based on estimates, Ford is trading 10x 2014 numbers, but if you normalize 2014 and 2015 for calendar disruptions, the earnings multiple falls to 9x.

Ford and General Motors are now trading at a steep discount to the market with single digit P/Es. The question investors face is why these stocks are trading at such a discount. Either this is a warning of problems to come or a market inefficiency that will lead to superior long-term returns. There are two primary reasons a stock will appropriately trade at a very low multiple: a broken balance sheet or declining earnings. Let's look at both possibilities.

Let's begin with the broken balance sheet hypothesis. In this case, the elevated chance of bankruptcy makes future cash flows more risky, depressing the multiple. Further, while a company may be profitable, it could lack the resources to repay or refinance its debt load. This is why over-levered companies trade at a discount to the market. Now prior to the financial crisis, the US auto companies were weighed down by horrendous balance sheets with high debt burdens, major pension liabilities, and a bloated cost structure. Since the crisis, these problems are gone. GM went through bankruptcy where it was able to shed or reduce many of these liabilities while negotiating a more reasonable deal with the United Auto Workers ("UAW"). The company carries $28.5 billion in cash against $32 billion in debt. Looking just at the automotive unit, liquidity of $37 billion far exceeds the $8.4 billion in debt. In other words, GM's balance sheet is far from broken; it is quite strong. Ford's auto unit has a net cash position of $9.1 billion. Further, its pension is far healthier with its unfunded status better by 50% to $9 billion. Ford had to do this the hard way as it did not require bankruptcy protection and has devoted cash flow over the past three years to right-size its balance sheet. Clearly, balance sheet risk is not a reason for the low multiple.

This leaves the second alternative: investors are looking for earnings to decline. If earnings decline for several years, a 10x multiple this year could be a 13x multiple later. In an environment where earnings are in decline, stocks should trade at a depressed multiple, which they will "shrink into." Given the low multiples of these stocks, GM and F are essentially pricing in a recession. Thanks to cutting costs, these companies have lower breakeven rates. Prior to the crisis, F and GM needed the US auto market to total at least 15.5-16 million cars to break even. Today, these companies can be profitable above 12 million (we are tracking at 15.5-16 million in 2014). In other words, the companies are immensely profitable at a level where they used to break even. As a consequence, there would need to be a major slowdown of significant proportions to destroy these firms' profitability.

Now, January auto sales were weak, though the weather in the month was horrible. However, these firms are keeping their first quarter and full year targets while they maintained a brisk sales pace in regions where the weather was decent (namely the West). Bad weather won't keep consumers from buying a car; it just delays the purchase. Moreover, these firms are continuing to grow sales in China and Asia, which continue to grow albeit at a slower pace. In fact, GM sells more cars in China than America. While Ford has lagged GM in Asia due to a later entry, it is growing sales dramatically and increasing capacity.

At the same time, the worst in Europe is behind us. Here, Ford has been a leader thanks to increased market share and painful capacity cuts. Ford should run near the flat-line in Europe after years of losses. GM has had a confused brand strategy and it has been slower to cut capacity, but it is starting to make the necessary cuts, which will help to cut the loss. In a sense, GM is leading in Asia while Ford is leading in Europe.

Yes, there have been some weak data points in the U.S. and elsewhere, but there is no sign of a recession. Further, rates remain low, which makes an auto purchase relatively cheap. The U.S. fleet is also older than normal, so the market will continue to benefit from pent-up demand. While Ford has a stronger product pipeline thanks to innovative products like an all-aluminum F-150, both companies have closed much of the quality gap and can compete against imported vehicles. With the U.S. economy slowly growing, strength in Asia, and capacity cuts in Europe, these companies will be growing profits over the next three years.

Ford and General Motors shares are trading at extremely low multiples that suggest the market is pricing in a recession. However, these companies continue to perform, and the underlying fundamentals of the auto market remain solid. Further, both companies offer 3.3% dividend yields, which provides solid ancillary income. Ford does trade at a mild premium to GM, though I think this premium is merited thanks to a stronger management team, better European operations and robust product pipeline. I own Ford and have added during this market dip. Still thanks to this indiscriminate selling, both Ford and General Motors are significantly undervalued. I would buy both stocks here and enjoy a strong multi-year run.

Disclosure: I am long F. 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.