Recession That Doesn't Kill Ford And GM Will Make Automakers Like Toyota Stronger

Summary

• Poor first-quarter numbers are inevitable; recession and unemployment look more likely by the day.
• Global production overcapacity is chronic and will impose the harshest test on automakers, notably the weakest. Nissan a case in point.
• As weaker automakers and parts suppliers fail or merge, conditions in the next expansion aren't guaranteed to improve.
• Looking for a helping hand in the market? Members of Auto/Mobility Investors get exclusive ideas and guidance to navigate any climate. Get started today »

Unlike the recent collapse of the Dow, S&P, and other major market indices, the share prices of General Motors Co. (GM) and Ford Motor Co. (F) have been on a steady decline for some time, GM since late 2017 and F since the summer of 2014.

GM and F versus S&P 500 since 2014 Source: Yahoo Finance

The reasons for the decline are numerous. One that stands out is the expectation and foreknowledge that automotive sales expansions - like economic expansions - don't last forever. Eventually, credit grows tight, consumers are worn out, everyone who wants or needs a new car has one - and it's time for a pause.

Whether automotive downturns cause economic downturns or vice versa is a perennial subject of debate. The coronavirus won't have caused the slump that's now certain; it will be the spark, the black swan that precipitated it.

The inevitable nosedive in the cyclical U.S. and global auto industry is beginning to unfold following an unprecedented 11-year run of strong sales and pricing in the U.S. after the global financial crisis. Almost certainly, the industry's next rough patch will accompany an overall economic recession for the U.S. and beyond, brought on by COVID-19 and related disruptions.

For investors in Ford Motor Co. and General Motors Co., the numbers of vehicles sold, the prices at which they're sold and the size of inventories will be the critical measures of the depth and breadth and duration of the downturn. Attention must be paid, especially if things stay bad for more than six months or so.

Ford has already suspended vehicle production in Europe indefinitely. The United Auto Workers union is agitating for a two-week shutdown in the U.S. Remember: automakers book revenue on vehicles as they leave the plant gate, not when they're purchased from a dealer.

Recessions have a silver lining

Are automotive slumps and recessions bad? If you're an investor with a long-term position in GM and F, an autoworker, a lending officer or a franchised car dealer, of course, they are. They also can be necessary and even healthy, according to the principles of market capitalism, insofar as they remove inefficient producers and outmoded products - clearing a path to innovation and new investment.

Given the run on grocery stores, it feels like the nation is in a state of alarm, which is entirely rational given the closure of schools, offices, and cancellations of major sporting events, Disney World and Broadway shows. How these measures affect U.S. cars will become fairly clear within weeks or days.

An underlying weakness of the automotive industry is chronic production overcapacity worldwide, which predates COVID-19. In short, too many factories chasing too few sales. Lately, the overcapacity has worsened, precipitated by a spate of new factories in China, many designed specifically for production of batteries and battery-powered electric vehicles (EVs).

Last year, LMC Automotive, a research organization, calculated that automotive factories worldwide ran at an average 61% of capacity with 89 million vehicles built from a capacity of 148 million. In the U.S., according to Jeff Schuster, president of LMC's global forecasts, 80% capacity utilization is considered the "magic number" for a break-even point.

For 2020, Schuster noted, LMC is forecasting another 4 million net units of capacity and up to 3.5 million fewer units built - which will pose a big strain on industry revenue.

Car buying demand in China, key to global automakers including GM and F, was "absolutely hammered" in February, according to Michael J. Dunne, a longtime expert on the Asian automotive scene who publishes the ZoZo Go newsletter. China sales for the month were down 80%, a 1.6 million vehicle miss - with GM down 92%, Toyota down 70%, and Honda down 85%.

Balance sheet durability is deterministic

The financial durability of GM and F through the coming downturn will say much about investor confidence in these two automakers for the longer term - GM having filed for bankruptcy in 2009 and F having brushed close to insolvency during the global financial crisis. Both automakers say they are operating far leaner and smarter today than in the runup to 2008. GM and Ford have told Morgan Stanley (MS) and others that they can make money until U.S. car sales fall to 10 or 11 million or less, down from the current rate of the high 16s.

If production drops drastically, by 90% supposes Morgan Stanley, free cash flow burn could be on the order of $4 billion a month each for Ford and GM, meaning that their reserves would be in danger within ten and nine months respectively.

Another critical data point will be if and when either automaker decides to cut or omit its dividend, as a financial precaution against a sustained or deep period of weak auto sales. Some investors no doubt will view Ford's 11.2% dividend yield and GM's 6.6% at current share prices too tempting to pass up. But the nation is just beginning to comprehend the enormous economic damage that could unfold in the coming weeks and months, which could make an impulsive short-term bet on either U.S. automaker a risky proposition.

Undoubtedly, some within top management and among directors will be arguing to cut or omit the dividend now, given that the investment community already is in shock, rather than later.

To survive is to win

Yet a recession that F and GM are able to survive in good order will add noticeably to their credibility as investments. Toyota Motor Corp. (TM), with the strongest balance sheet and highest credit rating among major automakers, isn't likely to rest on its laurels while competitors tighten their belts. Toyota has displayed discipline in weak periods before that can be counted on to do so again, even from its advantageous perch. Toyota has been preparing to be a host and sponsor of the summer Olympics - an event that may be postponed in the name of protecting public health.

Toyota's rival, Nissan Motor Co. (OTCPK:NSANY), is barely surviving following the arrest and flight of its one-time chairman, Carlos Ghosn. A prolonged period of weak vehicle sales would be a mortal blow, forcing the Japanese government to supervise a merger or reorganization, as the U.S. did for GM. Such an event could trigger the failure of Renault SA, whose most valuable asset is 43.4% of Nissan - worth $6.6 billion today and 0 in the event of a Nissan bankruptcy.

One could easily imagine that a Nissan insolvency or reorganization would neutralize - at least temporarily - a great deal of capacity, including in the U.S., relieving some pressure on the rest of the industry. What history has shown, however, is that overcapacity is chronic because countries (and now Chinese provinces) are willing to financially support automakers in order to create national industrial champions.

We are just at the beginning of the latest severe test for the global automotive industry. It's a reasonable assumption that not all producers will survive in their current form. Investors in F and GM should be focused on monthly sales numbers in the U.S. particularly, as well as inventory levels and production shutdowns by plant and shift, which will help paint the picture of the auto slowdown's breadth, depth, and duration.

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