As an investor, I have never purchased any shares of auto manufacturers due to their high cyclicality. To be sure, a rough year for auto manufacturers can erase profits of a whole decade. This was evident in 2008 when General Motors (NYSE:GM) filed for bankruptcy. Nevertheless, as the auto manufacturers are now trading at extremely low, single-digit P/E ratios, many investors are likely to be attracted by these stocks. Therefore, in this article, I will detail why General Motors is so cheap in order to warn those investors on the potential risks before they pull the trigger and purchase the stock.
First of all, General Motors reported excellent results in Q1, more than doubling its earnings over last year and widely exceeding the analysts' estimates. The company thrived in North America while it also managed to break even in Europe. Consequently, the estimates for this year have been raised by 5% since the earnings release. Moreover, the stock is now trading at a pronouncedly low forward P/E ratio of only 5.5 while it also offers a 5.1% dividend yield. Therefore, as the company is expected to grow by an additional 5% in 2017, it is only natural that many investors wonder why this stock is trading at such a cheap valuation.
First of all, investors should note that the auto industry is extremely cyclical and is now in the 7th year of its recovery, which stands in the middle of the typical post-recession recovery period of 6-9 years. Therefore, the market reasonably fears that the auto industry is relatively close to a peak, with significant downside thereafter. A report of Kelly Blue Book, which warned that the incentive spending was on the rise in the auto industry, only adds to the peaking concerns. During the previous cycle, auto manufacturers enjoyed exceptional profits in 2007 but collapsed soon after due to the Great Recession. To make a long story short, investors should be very cautious before purchasing these stocks in order to avoid buying near the peak of the cycle and incurring excessive losses as a result.
It is remarkable that the management of General Motors claims that the company is now better prepared for a similar crisis and is thus positioned to break even in a similar adverse scenario, in which the annual US auto sales fall from the current 17M vehicles to about 11M vehicles. On the one hand, it is safe to assume that the company is indeed much better prepared for a potential recession than it was nine years ago, as it should have learnt its lesson from its bankruptcy back then. On the other hand, due to the specific characteristics of the auto industry, no-one can be sure of the impact of a recession on the results of the company.
More specifically, auto manufacturing requires huge capital expenses every year only to remain relevant. Therefore, all car manufacturers carry excessive amounts of debt, which make them highly susceptible to any market downturn. For instance, General Motors currently has net debt (as per Buffett, net debt = total liabilities - cash - receivables) of $111B, which is remarkably high, even compared to the expected record earnings of about $9B this year. In other words, even if the company maintains its record profitability, its debt is about 12 times its record earnings, which is high by all measures.
It is also worth noting that General Motors does not have geographical diversification, as it generates almost 90% of its earnings in North America. Therefore, as the Fed raises the interest rates, the US economy is likely to somewhat decelerate from its current pace and hence the auto industry will feel the impact of the higher rates. Moreover, the higher rates will significantly increase the interest expense of General Motors, which is not negligible due to the above mentioned high outstanding debt.
Furthermore, the interest rate hikes will make it harder for consumers to pay off their auto loans. This does not bode well for the auto market, as the outlook of the subprime auto loans has greatly deteriorated recently. More specifically, according to Fitch, the 60-plus day delinquency rate of subprime auto loans packaged into securities over the last five years rose to a 20-year record of 5.16% in February. Therefore, there are reasonable concerns that the current record sales of vehicles may not be sustainable when the financing conditions start to tighten.
To sum up, while General Motors is trading at an extremely low P/E ratio, there are good reasons behind its valuation. If the US economy keeps enjoying uninterrupted growth, General Motors is likely to greatly appreciate from its current level. On the other hand, the company is highly susceptible to any downturn of the US economy, and hence the market is keeping a cautious stance on its valuation. While the company is better positioned for the next downturn and is not responsible for the high cyclicality of its business, it is in the nature of all the auto manufacturers to have huge capital expenses and high debt loads. This renders them highly vulnerable to any recession. Given that the auto industry is in its 7th year of recovery, and the outlook of subprime auto lending has significantly deteriorated recently, it is reasonable to fear that the auto sales are approaching a peak. As a final note, auto manufacturers are certainly not buy-and-hold stocks due to their inherent cyclicality. If one purchases General Motor, one should have great timing skills.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.