by Mark Bern
I recently had the privilege of interviewing Alan Mulally, CEO of Ford Motor (F), as part of an exclusive event by Seeking Alpha. The interview transcript can be found here and a link to my article here. That experience gave me the idea that I should do an overview article on the auto industry. I will start with an overview of the state of the auto industry from my perspective, then I will provide a short summary about several of the leading auto makers, and end with my thoughts of which company or companies offer the best investment based upon current relative value based upon my analysis. This analysis does not include ancillary industries such as auto retailers or auto parts manufacturing. (As always, I encourage readers to add their comments with additional information and perspectives following the article.)
Many industries are experiencing a very uneven recovery compared with past recovery experiences, and none more so than the auto industry. There are several factors that continue to weigh upon investor sentiment regarding the prospects for auto sales in 2012. Projections by Ford (included in interview linked above), J.D. Powers and wardsauto.com are ranging from slight growth to above 10% growth in the U.S. and emerging markets, and potential contraction in the eurozone. Most pundits agree that Europe will likely experience a recession in 2012, and that it began in the 4th quarter of 2011. The only argument seems to be about the degree of severity.
Growth is slowing in emerging markets such as the BRIC nations (Brazil, Russia, India and China) primarily due to attempts by those governments to curb rising inflation. Commodity prices rose faster than expected in 2011 and are forecast to rise again in 2012, but hopefully at a reduced pace compared to last year. With efforts in emerging nations to curb inflation, along with the timid pace of recovery in the U.S. combined with a recession in Europe, one would expect that demand should be assuaged enough to keep commodity price increases down to more reasonable levels. Such control of the global economy is difficult, and individual nations create a fine line between erring on the side of too much demand and not enough.
In addition, the recent events in the Middle East threaten, on an almost perennial basis, to create disruptions in oil supplies which could push oil prices much higher and further dampen global economic activity. If consumers find themselves paying even more at the pump, it is likely that many could delay major purchases of new cars and trucks even further into the future. However, due to the slack demand demonstrated during 2009 and 2010, there is significant pent up demand building, which will be unleashed at some point. We just can't be sure when that will happen.
Let's break down the trends and expectations by region. First, I'll start with the U.S. domestic market. In 2011, the preliminary sales figure is 13.1 million units sold in the light vehicle segment, according to wardsauto.com. Forecasts for 2012 sales range from 13.5 million to 14.7 million units from Ford (included in interview linked above) and J.D. Powers . In January 2012, comparable sales are well ahead of January 2011, showing an overall improvement of 11.4% according to the Wall Street Journal's market data site. If that level of improvement continues throughout 2012, the total sales would end up at about 14.15 million, about the middle of the range of expectations. Such an increase would do much toward keeping most automakers healthy.
The big question is how much would it help GM and Ford? While both GM and Ford increased market share in 2011, we don't know yet how strong the Japanese auto companies will be after suffering multiple setbacks to natural disasters in 2011. We'll have to monitor the development of how Honda (HMC), Toyota (TM) and Nissan (NSANY.PK) attack the U.S. marketplace in 2012 with the supply chains repaired and production coming back to normal levels. There also seems to be more shopping and a larger number of customers who were previously loyal to a brand that are willing to consider more manufacturers and models than before.
Another surprising factor is that U.S. auto exports are on the rise. The five largest importers of cars built in the U.S. are Canada, Germany, China, Saudi Arabia and Mexico. Total U.S. auto exports in 2011 were 1.56 million, and are expected to increase to 1.65 million in 2012 according to IHS Automotive. Labor cost reductions and production efficiency improvements combined with a much cheaper U.S. dollar have made building cars in the U.S. for export more cost effective, according to the HIS article. U.S. automakers have benefited from all these factors in 2011. The U.S. companies may assume that they will be able to continue to take market share, and they might, but thus far only Ford and Chrysler are continuing to increase sales while GM's sales were lower in January 2012 compared to January 2011, according to WardsAuto.com. ( A download of January sales of light vehicles is available here. I'll get into the details more as I look at each company.
Moving to Europe, the market is still distressed due to the decline following the vehicle scrap programs in 2010. The debt problems simply add another layer of risk to an already weak market. As recession sets in during the first half of 2012, the severity and length will be mixed from one country to another, but the overall trend will be a continuing decline in production and sales there. The current forecast by Ford for is 14 million to 15 million units in 2012, moving the midpoint of the range down by about 500,000 from estimates for 2011 (see interview article for source). That actually still seems a bit rosy to me. In order to profit in Europe, automakers will need to be more responsive to consumer desires and effectively manage costs.
Auto sales in emerging markets are still expected to grow in 2012, albeit at a more moderate pace. Growth in China's market, for example, is expected to be 9% in 2012, according to wardsauto.com and J.D. Powers. China is now the world's largest auto market, and success for many automakers will hinge on how well the companies can perform there and other fast-growing emerging markets.
Since the car market is relatively new (compared to North America and Europe) in China and other emerging nations, as more people find themselves able to purchase their very first car, brand loyalties may not be well established and pricing could become a significant factor. This could lead to a very competitive environment for automakers. Small car sales in India are stalling as the cost of borrowing has increased while. At the same time, fuel costs have risen, combining to make ownership less affordable for many on the lower end of the middle class expansion. My outlook for vehicle sales in emerging markets is one of caution, but the longer term (3 years or more) continues to look strong.
In Japan, Nissan appears to have been the least impacted by the natural disasters compared to Honda and Toyota. As production at the major Japanese automakers continues to ramp back up to normal levels, I expect those companies to compete vigorously to regain market share. By the look of things, Honda and Toyota are already making gains in the U.S., with Toyota posting a gain of 19.1% in car sales for January while Honda shows a 16.3% increase in car sales for January of 2012 compared to the same period in 2011.
The domestic Japanese market will likely resume normalcy in 2012, but while that is very important to Japanese car makers, it is not likely to have much impact on other companies. In the Japanese auto market, prospects are much improved with gains expected to be about 16% in 2012, according to J.D. Powers . Total sales volume is expected to be 4.8 million vehicles. The relatively large gain here is due to the lack of natural disasters that hurt production in 2011, creating pent up demand that will be relieved in 2012.
Taken as a whole, in my opinion the global auto industry is likely to see sales gain improvements in the first half of 2012 carrying over from robust gains in 2011. However, the 2nd half gains may depend more heavily on how the European debt situation develops and just how severe the recession there becomes. If the leaders of the eurozone are able to cope with the sovereign debt issues without allowing any significant disruptions, and the recession is of a mild nature lasting no more than three quarters, the 2nd half of 2012 could very well see the improvements that have been forecast. If not, the year could see volumes in Europe relatively flat from 2011 and earnings could be negatively affected on a year over year basis.
We need to keep a close eye on the quarterly reports to see how things unfold this year. And, of course, it could get even worse if the European debt issue becomes a real crisis and the web we call the global financial system begins to unravel in earnest. That is-- at this time-- a long shot for 2012, yet the possibility exists and should not be ignored. Now let's look at some of the individual companies that make up the universe of companies that an investor can invest in over U.S. exchanges.
General Motors (GM) appears to have regained its position as the leading auto maker by unit sales in the world after having been ousted from the spot four years ago. For a related story see this link. Just looking at the numbers, GM appears to be very well positioned for continued growth in both the top and bottom lines. The problem is that most of us just aren't buying the idea that the GM culture and management has changed sufficiently to continue to make improvements. Of course the debt situation is much improved. But will it stay that way? Even with its greatly improved capital structure, GM is still lagging Ford and Toyota with a lower net margin ratio. The company states that it intends to improve margins in the future but I have not been convinced that management has a comprehensive strategy that will effect that change.
Of all the major automakers, GM is the only company that doesn't pay a dividend yet. That is not a sign of a healthy company. This is not to say that GM doesn't have potential, because it definitely does. The company is very well-positioned in the emerging markets for future growth and it is holding its own in the U.S. market. Return on total capital is about 14% in 2011, which is relatively high compared to the auto industry average of 7%. The net profit margin is currently about 4.8%, just above the industry average of 4.5%, but I would have expected this ratio to be higher as a result of all the help the company received. The company has a storied history, but since it is still relatively fresh out of bankruptcy, it seems to me that we don't have enough relevant history to make a truly informed judgment.
For me, GM is still a wait and see story yet to unfold. The biggest question that I have not found a satisfactory answer to is whether the quality issues have been resolved. I am hearing mixed messages from the marketplace on this issue concerning GM products. I invite all readers who have purchased a GM vehicle within the last three years to share their experiences in the comment section below. It is anecdotal research, I know, but can still play a role in the evaluation. Of course, I don't want to pick on just GM; I'd really like to hear from those who have purchased any new car within the last three years, so we can create a comparative database from the feedback. Thank you in advance for commenting.
Ford Motor Company looks to have turned the corner, but I am not 100% certain that the company will be able to continue to execute its One Ford plan across all geographies. It is a bold plan that, if implemented fully, should provide Ford with cost efficiencies relative to most of the rest of the industry. The company will always have a higher debt balance within its capital structure because of the Ford Motor Credit unit. But that is not necessarily a bad thing, as long as the credit unit holds its own and doesn't drag down earnings. I don't expect problems from this area, as long as interest rates remain at historically low levels.
The test of management's skill in this area will come when we again enter a rising interest rate environment. If the company is able to effectively hedge its debt portfolio against the negative impacts of rising rates, performance of the overall company will not be dragged down by financing and earnings will remain dependent upon operational efficiencies, product quality and the company's marketing effectiveness, as it should. I don't pretend to know the answer in advance to this question, but felt it worthy of raising as a potential risk to watch in the future.
Outside of the debt issue, Ford looks pretty impressive by the numbers. Return on total capital is a respectable 10.5% while the net margin is about 6.2%, well above the industry average (4.5%). Ford recently reinstated its dividend and will monitor its uses of cash to determine whether to increase the dividend in the future. I believe that if management is able to remain focused on executing its strategy, there will be room to increase the dividend sometime in the next two or three years, and fairly consistently thereafter.
I want to stress that even though the auto industry seems to be regaining its health, there could be some speed bumps in 2012 (Europe, Middle East) and again in early 2014 (interest rates, potential inflation) that could test the resilience of this industry. Ford, to its credit, is making efforts in positioning itself to be better able to weather the storms. The question I have left is whether the company can complete enough of its transformation before the next storm hits, to be able to outperform its competition and remain profitable even during a recessionary economic environment. That would be a significant achievement and I believe the company is heading in that direction, but can it do so in time? How much time is there? Nobody really knows.
Volkswagen (VLKAY.PK) trades on the pink slips and is not required to make regular SEC filings. It is the second largest car manufacturer (by units sold) in the world, but due to the lack of available information and the fact that the company ranks 9th in sales in the U.S. I do not follow it. Sorry, VW owners. But please feel free to include comments if you've purchased a new VW in the last three years. The company's web site is interesting and its cars are presented very well.
I must admit that since I do not follow the company I haven't been to a VW dealership to check out the models first hand. As large as the company has grown, though, it is apparent that it is doing many things right. If I recall correctly, much of what Ford is doing-- standardizing its platforms and leveraging efficiencies in supply management and inventories-- started at VW. Please feel free to correct me on this issue if I am wrong. I don't make recommendations on companies that I do not follow, so invest here at your own risk. I just don't have enough information to perform a proper analysis. I suppose I should learn German.
Toyota Motor is the third largest car manufacturer in the world (by units sold). Until the financial crisis of 2008 Toyota appeared destined to rule the auto industry. Stuff happens. Falling sales (like all other auto companies), multiple recalls with huge publicity (much of which the company brought upon itself), natural disasters (earthquake, tsunami, floods) that disrupted production and supply chains have all hit Toyota very hard.
All of this commotion has created an opportunity, in my humble opinion. In 2011 the company will probably post another profit for the full year, but the competition has gotten stiffer and the company is unlikely to regain past levels of profit within the next five years. The company does have a history of raising dividends, having increased its dividend for eight straight years prior to 2009. The company's earnings fell from a positive $12.93 per share in 2007 to a loss of $2.84 in 2008, then rebounded to a positive $1.44 per share in 2009 and is expected to report at about $2.10 per share for 2011.
Assuming no further natural disasters or a global financial crisis, the coming year should show us that of which Toyota is made. I expect the earnings per share to nearly double in 2012 from 2011. The biggest concern for Toyota is its currency valuation relative to other major currencies. Continued strength in the Yen would make Camry and Lexus vehicles more expensive relative to competitors' entrees. This could require Toyota to hold down prices and eat the difference, in turn, cutting deeply into margins. Unfortunately, Toyota sports only a 1.5% net profit margin in 2011 and return on total capital is about the same. Improved capacity utilization and higher sales volumes will offset much of the currency woes facing the company, but it will take a herculean effort and time for the company to regain its former profit levels. Dividends will likely grow much more slowly than earnings as the company will continue to invest in efficiencies to hold down costs. But for the long-term oriented investor, Toyota may hold some appeal.
Daimler (DDAIF.PK) trades like VW, on the pink sheets, so I do not have as much access to information and cannot provide a recommendation on the company. From what I have been able to uncover, though, I like what I find. The company is better diversified than most of its pure automotive competitors with an aerospace unit as well as a financing unit. The net margin is about 5.4%, which is better than the industry average. Earnings had one bad year in 2009, and then jumped back to within a hair's breadth of earnings per share reported in 2007. It appears that the company is on track to report record earnings per share within the next four or five years. That is outstanding in this industry within the environment to which it has been exposed.
Nissan Motors (NSANY.PK) is another foreign company trading on the pink slips in the U.S. Once again, I will not be offering an opinion on Nissan. The company is close behind Honda in U.S. car sales as it seemed to experience less supply chain difficulties from the flooding in Thailand. It is also gaining ground in market share on both Honda and Toyota. The company is likely to post a net margin of about 3.5% in 2011 based upon results thus far available.
This is another more diversified industrial company with operations including the production of pleasure boats, outboard marine engines and lithium-ion batteries as well as parts for the OEM and after markets for autos. The company has become a leader in the manufacture of all-electric cars. While the concept has a lot of political support, I'm not sold on the idea that electric cars will replace a significant number of autos in the U.S. There may be a better market for these vehicles in some of the emerging markets, where long-distance travel is still not a regular occurrence for most people.
Tata Motors (TTM) the Indian carmaker that also owns Jaguar/Land Rover is an interesting company. Again, the company trades on the pink slips and there is not sufficient data available to me to perform a complete analysis. However, the company seems to be learning a great deal from its Jaguar/Land Rover subsidiaries in terms of design. That could help the company if it intends to compete in the U.S. and European markets in the future with its Nano subcompact and the Pixel city car. The company is facing slowing growth and heavy competition in the small car market within India. But the long-term potential is still there if the company can overcome the short-term obstacles.
Honda Motor (HMC) has suffered some of the same fate as Toyota-- as have all the Japanese automakers, with the exception of the highly publicized recalls. I expect Honda's net margin for 2011 to be about 3.0%, below the industry average but respectable considering what the company went through this past year. The one thing about this company that really stands out for me is the fact that it did not lose money during the great recession. Earnings were down significantly, but unlike every other major company in the industry (outside of local companies in emerging markets like China and India), Honda management was able to manage positive earnings through it all.
Again, 2011 was another setback for Honda, but I expect 2012 to be the year in which Honda will show us just how strong a competitor it is. It will not vie for world domination; it is a niche player. Honda won't even dominate its own domestic market. The company is Japan's second largest auto manufacturer and the world's largest manufacturer of motorcycles. I think this is a salient point to consider: as fuel prices continue to trend higher, fuel efficiency will continue to become more and more important. Laugh if you will, but motorcycle sales seem to thrive in the emerging markets within this environment. The company continues to be recognized for its fuel efficiencies, quality, and value. Those are characteristics for which every auto company longs.
I believe that in 2012 we will see margins expand, in spite of the strength of the Yen, and earnings get back on track toward record levels within the next five years. Now, an investment in Honda is not likely to perform as well as an investment in one of the other companies like Ford, GM or Toyota, but I do feel the risk adjusted return will work out to be higher. What I mean is that you are taking on less risk of loss with Honda, while retaining the potential for an above average return. From my point of view, at this particular point in time, I believe that Honda is the best potential investment in the auto industry.
Well, there you have it. You don't have to agree with me, but I hope that you'll respect my right to an opinion as much as I respect yours. The auto industry has significant upside potential as long as the world economy continues to improve. This year holds both promise and uncertainty wherever one looks. That is why I am remaining cautious and conservative in my investing approach.