The past three months have not been kind to US automakers with GM (NYSE:GM) down 6.5% and Ford (NYSE:F) down 9.9% (chart below). After several years of improving sales, some investors are growing concerned that the U.S. auto market has hit a speed bump. While the pace of sales has slowed a bit, the weather has been unseasonably bad in many parts of the nation, especially compared to some recently tame winters. This weather has made it more difficult to detect whether the US economy is seriously slowing down or merely being impacted by the weather. In the auto sector, the prevailing view seems to be that there is a slowdown that is causing mass discounting, which will erode margins. Based on the data and forecast, this view is overly pessimistic.
(Chart from Google Finance)
First, it should be noted that buying or selling based solely on one month's data is a dangerous games. The economy (and markets for that matter) does not move in straight lines. Upturns have soft spots while downturns can have temporary strength. By focusing exclusively on each data point, an investor can lose the forest through the trees. For the past three years, auto sales and automakers profits have improved. One weak month is not proof that this trend has come to a close.
Reuters came out with a report (available here) that has many investors concerned. Because sales have been relatively robust, pricing has been strong. Automakers have enjoyed a rising tide rather than fight for each bit of market share. With the market supposedly slowing, Reuters notes an increase in discounts, which is not good for profit margins. According to Reuters, some dealers are discounting the Ford F-150 by $8,000 and the Chevy Silverado by $9,000. Some of these discounts are being eaten by the dealers and not the manufacturers. Ford's discount on the F-150 is $4,000 while GM is discounting $7,000 from the Silverado.
On its face, this is bad news, but a close examination of the report provides a fuller picture. GM's average discount in February was $3,204 while Ford's was $3,305. These numbers are well within historic norms and not as drastic as some have suggested. Further, transaction prices are at a record of over $29,000. While some like Autonation's (NYSE:AN) CEO Mike Jackson have said inventories are getting too high, pricing has not collapsed (details available here). In fact, there are specific reasons why the F-150 and Silverado have been heavily discounted.
Ford and GM are refreshing the products with a lighter Silverado and a revolutionary aluminum F-150. It is typical in virtually all industries to discount an existing product to make room for a newer product. Investors don't fret when Apple (NASDAQ:AAPL) discounts an old iPhone after announcing a new one. These discounts are analogous. When new products come on the market, we should see pricing firm up. In fact, 2014 is purely a transitional year for Ford as it launches a record 23 new products (details available here). While this will adversely impact sales in 2014, I expect 2015 to be a banner year with over $2.00 in earnings.
While inventories have gotten a little high, I expect the auto market to maintain a 15-16 million run rate in 2014. The average car on the road is over 11 years old, which is a new record (details available here). Because of the recession and slow median wage growth, Americans have deferred new car purchases. At some point, it becomes more economical to buy a new car than maintain an old one. An aging fleet will provide pent-up demand for the next two years and keep US auto sales robust.
Investors need to also recognize that Ford and GM are not just plays on the US auto market. GM sells more vehicles (albeit at a lower average price) in China than in the US (financial and operating data available here). Similarly, Ford is growing its sales in China by 50%. Global results will be stronger even if the US market slows down. Similarly, both companies are doing better in Europe. I expect Ford to break even on the continent this year while GM should by 2016. With the European auto market stabilizing, results on the continent should start to improve. Strong Asian sales and am improving Europe make these stocks attractive.
GM and Ford have cut their cost structures and have new products in the pipeline, which makes present concerns about discounting overstated. Both stocks are trading at less than 10x normalized earnings with dividend yields of over 3.3%. Pent up demand and a strong product portfolio will make US sales better than feared over the next twenty-four months while discounting will not be a major drag on margins. International divisions will also provide incremental earnings power over the next three years. The auto market is not facing collapse; both GM and Ford are extremely undervalued and attractive stocks.