U.S. Auto Undervalued - A Yield And Value Opportunity

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Includes: F, GM
by: Luke Jones

Summary

The auto industry has inherent risks which dictate caution for both the short and long investor.

GM and Ford pricing provides fundamental support for starting a position.

The yield opportunity provides further support to balance industry risk.

GM and Ford have improved their balance sheets significantly to weather a downturn.

US automakers have been left for dead in the equity markets since the Great Car Crash of 2009. I was lucky enough to be working at an auto plant at that time and remember those dark days, but we should not let previous calamities prevent us from seizing a rare opportunity at a time when the S&P 500's P/E is at 25, a historically significant peak.

Historical S&P 500 P/E

Source: http://www.multpl.com/

A Fundamental Review

Both General Motors (NYSE:GM) and Ford (NYSE:F) are trading at very low multiples when compared to the market. If both were purchased evenly to fill a position, you would have a position trading at only 22% of the P/E of the market and a PEG of 0.53 (well below the recommended ceiling of 2). P/B is approximately half the S&P average which is reasonable given the higher risk during a downturn. The dividend of 4.5% would more than double the S&P despite a lower payout ratio.

The position would, however, have a lower operating margin at 5.75% vs. 7.85% for the S&P. The combined leverage ratio is in line with the S&P, a blend of GM's at less than 1 and Ford's elevated leverage at 1.76. The volatility is also high at a beta of 1.45.

Overall, the depressed pricing presents a tremendous amount of room for capital appreciation with a high barrier to further depreciation over a long horizon. Even if the price continues to stagnate, the 4.5% dividend will provide a steady income and the payout ratio indicates that there is a high probability of dividend growth in the future. Both companies have raised dividends the previous 3 years, a healthy start given the dire situation prior to that. Another economic crash could cause a change in direction though for the dividends.

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A Defensive Review

With a solid fundamental base for investment, we now focus on the risk level of the investment. During 2008-2009, GM went bankrupt and Ford very narrowly avoided it. Global auto sales crashed by 33% during this period and US auto sales by 50% (source: Statista). Sales generally returned to base within 2 years. This was an extreme situation but let's review the financial statements to understand if they are better prepared today.

For GM, a 33% reduction would be ~$50B/year in lost revenue. They have a strategy documented in their annual 10-K report that they will keep $20B in cash and equities and have a total of $32B in liquidity for their automotive arm. If you include cash used for stock repurchasing, 50% capital expenses, and dividend payments as liquid ($9.6B total), the total is $41B. The remaining $9B would be required to come from reduced purchases and production or borrowing capacity on unpledged eligible assets. (All info from December 2015 10-K). In total, GM should be able to scrape past a similar economic condition, although there are many factors which could tip the scale in the wrong direction.

For Ford, a 33% reduction would be ~$46B/year in lost revenue. I did not see language in their 10-K with a specific cash target but they have averaged $12B across 2014 and 2015 with another $20B in marketable equities for $32B total. Adding in cash allocated for stock repurchase programs, 50% capital expenses, and dividends, the total can be brought up to $42B. The remainder would need to come from reduced purchases and production or borrowing. (All info from December 2015 10-K). In total, Ford is in a situation similar but slightly better than GM where they should be able to cover the automotive decline for a short period.

It is important to note that I have not included impacts to the financial arms or pension obligations in the analysis above. Despite this, I feel comfortable that these companies are better suited to handle a global crisis than a decade ago and are suitable for my investment.

Conclusion:

US auto manufacturers GM and Ford have very favorable valuations in today's market with solid fundamental support. While a combined beta of 1.45 and known cyclical risk is inherent with the auto industry, a 4.5% dividend and improved balance sheets offer a compelling argument to initiate a long position.

Sources:

All financial info from Yahoo Finance (www.finance.yahoo.com) unless otherwise noted.

Disclosure: I am/we are long F, GM.

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.

Additional disclosure: All investors should exercise due diligence in doing their own research before initiating a new position. Do not use this as investment guidance but as an opinion.