In the past year, there have been extensive reports about the financial success of American automakers GM (NYSE:GM), Ford (NYSE:F), and Fiat-Chrysler (NYSE:FCAU) (though not strictly an American manufacturer, I have included it because the company's results exhibit many of the same trends as its traditional American foes).
These companies have sold volumes not seen since before the financial crisis and logged all-time record profits for their shareholders. Ford even announced a special dividend, while GM plans to repurchase $5b in shares by the end of 2016. Many analysts are forecasting even higher sales numbers and profitability for next year.
Despite all of these positive attributes, investors have not been kind to these auto manufacturers over the last year. As shown below, all three have underperformed the S&P 500, positing significant negative returns over the time period.
Admittedly, I was a little miffed by these results. These three companies, especially Ford and GM, appear to be perfect value investments right now given their impressive cash flows and depressed metrics. In the wake of disappointing earnings and volatility, surely investors would reward the stable and growing cash flows of these manufacturers.
One possible explanation is that these manufacturers are facing concerns about the profitability and even viability of their emerging markets operations. GM missed its first quarter earnings in 2015 in part due to weaknesses in Latin America and Russia, for example. Ford's results were hampered by underwhelming integration into China, which is regarded as a large untapped market for U.S. manufacturers.
To be sure, these developments are less than ideal, but they do not account for much of the discrepancy between financial and market performance for auto manufacturers. In the U.S. alone, GM, Ford, and Fiat-Chrysler experienced volume growth of 5%, 5.3%, and 7.3%, respectively in 2015. The volume growth also outweighed the loss in volume from economic headwinds in emerging markets. For example, in the third quarter, GM reported than increased volume in North America offset declined in emerging markets to add $1.8b to net revenue and $0.7b to EBIT.
Additionally, all three companies saw domestic growth in their average selling price of new vehicles of 2.9%, 3.3% and 3.3% respectively, outpacing the national average of 2.6%. These gains largely came from the increased purchases of SUV's and trucks due to falling fuel prices, which command a premium price over small cars and are higher margin for the manufacturers. Comparatively, many other global auto manufacturers have not been able to capitalize on these gains without a competitive line of trucks.
To expand on this point, all three auto manufacturers are entirely dependent on their North American division, and specifically U.S. sales, to make any profits whatsoever. In the third quarter, both Ford and GM reported losses in every other geographic region besides North America (with the exception of GM's Asian operation), and their North American operating profit exceeded their consolidated operation profit. Fiat Chrysler's North American operation accounted for 100% of its operating profit excluding its unique super car divisions Ferrari (which has since been spun off) and Maserati. For this reason, the U.S. market is essentially the sole determinant of each company's profit and cash flows for a given period compared to relatively miniscule operations in emerging markets.
If the record-breaking results from the U.S. outweigh international risks and headwinds for these auto manufacturers, the question still remains as to why investors are not rewarding these companies with higher valuations. I believe the issue boils down to sustainability: the fact that while pleased with the current results and capital returns, investors remain skeptical of how long these manufacturers can continue their recent performance.
As I alluded to earlier in my article, 2015 was a banner year for all three auto manufacturers. Both analysts and leadership within these three companies expect the trend to continue in 2016, with some analysts projecting that U.S. sales will break the newly established record in the past year.
However, as anyone who has created a DCF can tell you, the majority of a company's value to (long-term) shareholders comes from the cash that they are anticipated to generate in the foreseeable future, not just in the next year. Despite their resurgence at present, the future of 2017 and beyond for auto manufacturers is considerably less certain and rosy than their immediate prospects.
There are several reasons why I believe investors are concerned about the medium-long term future, which are not necessarily of the manufacturers' creation. Currently, the global automotive industry is one of the most competitive on the planet, where each consumer can choose from dozens of possible makes and models of new cars. Every auto manufacturer has to tailor their lineup to satisfy a wide range of factors for a diffuse set of consumers, who weigh the importance of factors such as price, features, style, and safety very differently among themselves. The sheer number of automotive brands available in a global economy has created a price war to the bottom among nearly all manufacturers (with the exception of those appealing solely to affluent customers).
Additionally, the global automotive industry is extremely volatile, and the fortunes of even the market leaders can change in a heartbeat without any warning whatsoever. It has been nearly a decade, but I doubt that investors have forgotten about how massive bailouts or bankruptcy proceedings needed to save the U.S. automotive industry during the recession.
Unfortunately, this volatility is intrinsic to the industry because of the importance of new sales volume in determining profits and cash flow. The automotive industry is notorious for having enormous fixed costs of both capital and labor, especially because the agreements with the UAW make it difficult for manufacturers to cut personnel or wages in periods of lower demand. Subsequently, the key to making profit is for these companies to sell a high volume of vehicles, which lowers the average fixed cost per unit and improves margins. However, if the volume is too low, these manufacturers may incur losses because they will not be able to fully recover their fixed costs in a given year. This is of course what happened during the recession.
While other industries have high fixed costs, what makes the automotive industry so unique and volatile is the fact that demand for new vehicles is highly cyclical and can change greatly without warning. For example, new cars sales were nearly halved in 2008 due to lower demand stemming from the beginning of the recession. Though there were extraordinary circumstances in 2008, sales of new vehicles can swing so drastically because they are largely considered to be discretionary or luxury purchases by most of the population. If consumer confidence falls or economic fears stir, then a new car would be one of the first purchases that most consumers would postpone since it is not essential or a necessity.
On the backdrop of these concerns, it is ironic but natural that the automotive market's recent strength is the primary factor driving investor and insider concerns. From the investor's standpoint, the main issue is not so much about current performance but about maintaining growth of new car sales, revenue, and cash flow.
Within the auto industry, many are worried about a growth plateau settling over the industry in 2016 and beyond. In 2015, overall auto sales increased 5.7% from the previous year, but many experts are predicting low single digit growth for 2016, possibly as low as 1%. For example, Hyundai's North American CEO said "If you look at historical industry cycles, it has generally been about a seven-year run. We're nearing the end of a good seven-year run, and I definitely think it starts flattening out, though I don't see a collapse." Moreover, former General Motors vice chairman Bob Lutz advised automakers and suppliers to "[not] increase capacity. [Instead], try squeezing every car out of the capacity you have."
At present, there are warning signs of a growth plateau settling in. Online retailer AutoNation (NYSE:AN) ended 2015 with 20-25% more inventory than the previous year, while seeing gross margin per vehicle diminish. Aggregate used car sales have fallen in value, indicating that new car sales are currently meeting a greater proportion of the aggregate car demand in the U.S. market. Moreover, the average sales price for new cars excluding trucks and SUVs, for which there was significantly increased demand in 2015, was essentially constant after consistent increases since the recession.
These trends have not been lost by leadership among the manufacturers, who have admitted to challenges in the coming years. In early 2016, Ford warned that its North American operating profit margin are likely to decline slightly to 9.5%, due to new investments needed to remain competitive into the future. Ford's CEO even noted that investors are "are waiting to see how [Ford will] do in the downturn." Further, he admitted that Ford is hoping to eliminate some of the cyclicality of its earnings, indicating that he saw a sales plateau on the horizon. GM President Dan Ammann stated that GM planned to reduce capex from 5.5% to 5% of revenue from 2016 onwards, in order to maintain its capital return to shareholders.
Long-Term Future Uncertainty
At present, the auto industry is in the early stages of a technological revolution, and no one is certain how the impending changes may affect the incumbent industry leaders. In the past two decades, many of the changes in the industry have revolved around developing increasingly smaller and more fuel-efficient cars in response to the rising retail gasoline prices and to meet regulatory emissions and fuel-mileage standards. In this time, we have seen the adoption of new propulsion technology, including hybrid internal combustion-electric motors, ethanol-powered engines, and more recently, entirely electrically-powered engines. The adoption of these technologies has proven costly and time-consuming to develop, resulting in expanded R&D and Capex budgets for many manufacturers.
However, these changes were markedly different than the possible changes on the horizon because these evolutions in propulsion technology did not threaten the existence of the entire automotive industry as we know it. Yes, some company such as Toyota (NYSE:TM) have been able to capture market share by being the first to heavily invest in hybrid technology. But at the end of the day, all of the global auto manufacturers have adapted to new regulatory and consumer demands with minimal change in the power structure of the industry. Even as hybrid and electric vehicle began to proliferate, the same companies, including the American manufacturers, continued to dominate the global and domestic auto market.
In contrast, I believe that the new developments of driverless cars and ride sharing threatens to permanently and dramatically alter the entire auto industry. For the first time in history, automotive technology is being driven by forces outside of the automotive industry, including Google (NASDAQ:GOOGL) through their driverless technology. Though it may take decades, there seems to be little doubt that driverless technology will eventually dominate automotive transport. This raises many long-term questions for our auto manufacturers, including whether they will be able to develop driverless technology, or whether one firm might gain a remarkable edge by integrating it first.
In addition, there is the intriguing question of how ride-sharing services may interact with traditional auto manufacturers in the future, which has been driven by GM's $500m investment in Lyft. The short-term expectation is the GM will supply Lyft with a fleet of vehicles which Lyft drivers can rent out at a discounted rate. This will also have the benefit or "free" advertising of GM vehicles to Lyft customers. However, GM hopes to develop driverless technology and integrate Lyft's services to allow cars to show up anywhere within a certain range at a customer's request. Extrapolating this trajectory out and assuming this technology is eventually successful, I could envision a situation in which individuals living in urban areas reject traditional car ownership altogether in favor of this ride sharing service.
Of course, predictions at this point about the long-term future of the auto industry are fruitless. No one knows whether such a service will truly be developed, or whether it would be developed. No one can possibly estimate the impact of this new technology on new car sales, and whether current auto manufacturers may have different streams of revenue in the future. However, my only point here is that investors may be concerned about the long-term future of automakers beyond the next five years or so.
Despite all of these concerns with the automotive industry, a large decline in new sales volume is highly unlikely in the next several years, at least in the critical U.S. market. Even if the growth rate of new car sales slows, it is highly likely that manufacturers will set a new record for new cars sales in the U.S. in 2016. Continuously falling oil prices are returning money to individuals' hands, and consumption excluding auto sales has remained fairly consistent even with this tailwind. Consumers appear to be saving for "big-ticket" purchases, such as a new car, as evidenced by the limited growth in retail sales excluding autos. There has been little evidence to suggest that this trend will change for 2016.
In addition to increasing disposable income, low oil prices will continue to augment demand for large trucks and SUVs as it has in the last year and a half. Since its initial plunge, oil prices have not only remained low but have fallen even further in 2016 to levels not seen in decades. This has helped convince consumers that the initial 2014 plunge was not a fluke but a permanent shift in the market, paving the way for consumers to feel more comfortable purchasing fuel inefficient vehicles. In this regard, oil prices have increased demand for large vehicle because lower retail gasoline prices decrease the lifetime costs of operating the vehicle, and because gasoline prices equate to real savings which consumers can use to purchase these more expensive vehicles in the first place.
Even if sales of small cars stagnate or decline in 2016, Ford, GM, and Fiat-Chrysler are still positioned to benefit from the growth in demand for large trucks and SUVs. In the past year, all three manufacturers experienced higher growth for these vehicles than across their entire product lines. For example, Fiat's Ram truck brand grew sales by 5.3% and its Jeep brand by 24.9% in 2015. In fact, Jeep sales became stronger as 2015 progressed, increasing by 41.7% in December. Likewise, GMC (GM's luxury SUV and truck brand) increased its sales by 11.3% in 2015, including by 13% in December. At present, all three manufacturers are the unquestioned leaders in the large vehicle market, with all manufacturers occupying the top four spots among the best-selling trucks in the U.S. and vastly outselling the 5th place Toyota Tundra.
Additionally, the demand for new vehicles is unlikely to drop off significantly due to the need for replacement vehicles. At the end of 2014, the Department of Transportation estimated that the average age of American vehicles on the road was 11.4 years, which was higher than at any other period in the last 20 years. Despite the bevy of new cars in 2015, there are still many vehicles which need replacement, which will continue to sustain demand for 2016 and beyond. Rather than pay high maintenance costs for old vehicles, it is easier for many consumers to spend the money now (while they have savings from lower gas prices) and purchase a new car. This is also consistent with auto sales growth exceeding retail sales growth, as explained earlier.
As it pertains to car sales, the recent volatility in global indices may prove beneficial insofar as it will likely delay further Fed rate hikes and hold market rates near their current levels. Most consumers finance new car purchases through loans, whose rates can vary greatly dependent on the market conditions. For example, one analyst estimated that a 100bps increase in car loan rates would equate to a decrease of about $1,000 in consumer budgets for new cars. However, this likely will not come to fruition as soon as expected if the Fed slows its expected rate hikes.
Based upon the aforementioned analysis, I remain cautiously optimistic that these automakers will outperform the market in the near future, but I am uncertain more than 2-3 years down the road. I believe that investors have given too much weight to the concerns about future of the industry and weaknesses in emerging markets, ignoring the successes which have driven profits to record levels. As I described, these are valid concerns, but they will not have a material impact on financial success over the next few years.
The main reason why I am hopeful that these companies will outperform is due to their impressive and growing cash flow, which all companies are diligently returning to shareholders. Between 2012 and 2017, GM is projecting to return over $23b in cash to its shareholders, which amounts to a return of about 50% of its market cap in a 6 year period. All three manufacturers have boosted their dividend and/or buyback programs within the last year, and are even scaling back internally wherever possible to support these capital returns.
I hope that this article provides more clarity as to why the leading U.S. automakers' performance has lagged the market in spite of their meteoric rise in profits. I do believe that the potential to outperform remains present for all three companies, but it may not come to fruition if investors continue to focus on industry risks and uncertainties more than current results.
Disclosure: I am/we are long 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.