Industry and stock outlook
Regarding the delays in the recoveries of the Chinese and US markets, the major cause of earnings deterioration of the auto sector, we believe: 1) the Chinese market, although likely to recover in the mid to long term, will begin to recover from 4Q18; and 2) incentive declines will happen faster than anticipated thanks to increasing exports and new vehicle effects in the US. We expect earnings recovery to be led by finished vehicle makers (Hyundai (OTCPK:HYMTF) first, then Kia (OTCPK:KIMTF)). However, as displayed by the 2Q18 results, despite the delay of recovery in utilizations at HMG, the profitability decline of auto parts suppliers in China should be limited.
Korea's five major auto names’ domestic shipments in August up 2.1% to 302K units
Despite fewer business days in August, Hyundai’s shipments increased on consumption tax breaks on vehicles, faster- than-expected resolution of management-labor negotiations, and a favorable base caused by the absence of labor strikes. - Meanwhile, all the other automakers except Hyundai saw a decline in shipments. The average YoY shipment growth of the five Korean majors was 2.1%, vs. Hyundai’s 39% and Kia’s -7.2%. New vehicle sales in August: Hyundai G70 1,138 units, Santa Fe 9,805 units (+121%), Veloster 681 units (+5575%), Kia K9 1,204 units (+1464%), K3 2,668 units (+23%), and Ssangyong Rexton Sports 3,412 units, +86%.
HMG’s global wholesales volume in Aug: 608K units (+5.5% YoY, +5.0% MoM)
Hyundai’s global wholesales volume: domestic 103K units (+7.5% YoY), overseas 505K units (+5.1% YoY). Kia’s overseas sales were sluggish due to weak Chinese demand and several strikes domestically before labor and management came to a resolution. However, Hyundai’s successful labor-management negotiations, growing new vehicle exports, favorable base in the Chinese market, and Kia’s solid sales in other parts of the globe (Russia, LATAM, MENA) helped defend overall volume. Hyundai’s wholesales volume: global 384K (+9.2% YoY, +10.8% MoM), domestic 59K (+7.4% YoY), overseas 326K (+9.5% YoY). Kia’s wholesale volume: global 224K (-0.2% YoY, -3.7% MoM), domestic 44K (+7.7% YoY), overseas 179K (-2.0% YoY).
Watch for the timing of Chinese recovery and the bottoming-out of US earnings
Slow Chinese sales likely to recover in the mid to long term: Since 2Q18, HMG has been reducing its shipments to reduce inventory burdens in China. However, contrary to worries, fixed-cost burdens stemming from the operation of the plant unit #4 and #5 and worsening product mix due to the low ASP of vehicles which saw a net increase in sales have had limited impact on earnings. Auto parts makers with large exposure to the Chinese market may suffer a delay in the recovery of profitability. From September or October onwards, Chinese sales should recover on strong seasonality and momentum from new vehicles such as Tucson F/L, La Festa, and Yipao.
The inflection point of US earnings recovery: Inventory level has come down to a steady level of three months thanks to production adjustments following the introduction of Hyundai’s Santa Fe and Kia’s SUVs as well as the reduction in shipments of slower selling sedans. We expect to see a meaningful decrease in incentives from August or September when dealer inventory increases due to reduced inventory and the introduction of new light trucks.
Depreciation of USD and other currencies negative but impact limited
The movements of major currencies are favorable for Hyundai and Kia. Other currencies are not so favorable, but their impacts are limited. USD and EUR movements are more favorable vs. 1H18. In 2017, 32% of Hyundai’s exports out of its domestic plants were bound for the US. Favorable FX is positive for the parent company’s profitability and pricing strategy in overseas markets. The recovery of utilizations in domestic plants helps to boost exports, which is also positive for the parent company. The weakness of other currencies should have a minimal impact on earnings. As seen from the 2Q18 results, it is offset by strong demand, higher utilizations, price hikes and product mix improvements.
Focus on Hyundai Motor for its earnings look set to grow faster than others until 4Q18
Hyundai is expected to see a gradual recovery of earnings in North America from 4Q18, should help to protect the overall earnings of the sector. Chinese retail demand should recover from October because the August and September period is a slow demand season. As such, we believe auto parts manufacturers’ earnings recovery will still be delayed. However, as seen from the 2Q18 earnings results, further downside for earnings is limited thanks to cost-cutting effects. In North America, HMG is likely to see incentives come down on the back of low inventory, which should contribute to an earnings increase of finished vehicles in the short term. Especially, from September when dealer inventory is expected to increase after the introduction of Hyundai’s Santa Fe, the incentive decline should pick up pace, leading to a significant increase in operating profit toward the end of 4Q18.
Currently, the sector is trading at the lower end of the historical bands. While there are risks such as US tariff issues, we are more inclined to believe earnings from North America will gradually recover. We recommend investors to make a defensive portfolio that is mainly comprised of Hyundai Motor Company for its prospect of earnings recovery in North America driven by Santa Fe, Hyundai Mobis (OTC:HYPLF) for its earnings stability, and Hankook Tire (OTC:HAOOF) as the stock has been severely oversold despite the prospect of earnings recovery in 2H18. We also recommend selectively approaching other stocks such as Hanon Systems and Mando for they have limited exposure to HMG’s delayed recovery of Chinese shipments.
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.
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