Bull Vs. Bear: Major Automakers Face A Tough Road Ahead

By Stephen D. Simpson, CFA | July 09, 2012 AAA

Question: Are automakers a smart investment right now?

Bear's Response
The auto industry has certainly enjoyed a meaningful recovery from the worst of The Great Recession, when both General Motors and Chrysler declared bankruptcy and Ford (NYSE:F) came under serious stress. It wasn't just an American phenomenon either - even mighty automakers such as Toyota (NYSE:TM), Nissan (OTC:NSANY) and Honda (NYSE:HMC) saw major declines in sales and profitability, and a host of European carmakers saw substantial stress.

While auto sales for the major automakers may be better than its lowest levels, that doesn't mean that major automakers represent great investments today. Not only are these companies facing a challenging demand environment, but production costs are increasing and this industry has a decidedly mediocre history of financial performance.

SEE: 9 Cars That Can Rebuild The American Auto Industry

Stressed Consumers Are Not Reliable Buyers
While the "Cash for Clunkers" program was a thinly veiled subsidy to the auto industry and recent auto sales numbers have looked strong, this performance has to be kept in context. Recent auto sales levels are on the magnitude of those seen in 1991 and 1992 - not exactly a strong sign of secular growth.

What's more, manufacturers and dealers have to continue to offer attractive financing, cash back, trade-in allowances and other incentives to get customers to sign on the dotted line. Consequently, profits at the major manufacturers still aren't all that good, even though they may look impressive on a year-on-year basis.

Consumers are still under a lot of pressure. Unemployment in the EU is over 11%, U.S. unemployment is over 8%, and the economies in major emerging markets like China and Brazil have definitely slowed. None of that speaks well to the sort of big-ticket purchase that a car represents. What's more, high gasoline prices and more stringent auto loan qualifications are forcing many customers to move away from the larger, more profitable vehicles that used to prop up auto company profits.

SEE: 5 Other Countries Affected By A Troubled Europe

The Cost of Staying In the Game Continues to Increase
Consumer demand and government regulation continue to impose high cost demands on the auto sector. The sudden spike in gasoline prices a few years back stimulated demand in ultra-efficient and hybrid vehicles, but these are not easy (or cheap) to develop and manufacture. For starters, there are substantial upfront costs in terms of R&D, prototyping, testing and tooling that simply cannot be avoided. While companies like Volkswagen, Toyota and Daimler AG can afford these costs, smaller companies like Subaru (part of Fuji Heavy Industries) don't have the same sort of scale.

Toyota has seen enough success with the Prius that it can manufacture the car in significant volumes; allowing the line to go from a money-loser to a profit-maker (albeit at a lower margin than the company's other lines). By comparison, Honda, GM and Nissan have not had the same success with their hybrids and/or electric vehicles, and they have weighed on results.

SEE: 4 Ways Rising Fuel Costs Influence The Auto Industry

These pressures are not going to abate. Countries continue to impose stricter standards on fuel mileage, pollution and safety, and these requirements carry costs. Companies like Autoliv (NYSE:ALV) and BorgWarner (NYSE:BWA) aren't running charities, and it takes time for new technologies to achieve profitable economies of scale.

An Industry with an Iffy History
There is no fail-safe metric for judging a sector, but fundamental metrics like operating margin and return on invested capital are pretty reliable guides to successful companies and successful long-term investment candidates. Unfortunately, the auto industry scores poorly here.

Ford's long-term operating margins and ROIC have been rather poor, as have those of GM, Daimler, Volkswagen and most other major manufacturers. The major Japanese companies (Toyota, Honda and Nissan) do score substantially better, but even their mid-to-high single-digit ROICs are nothing to celebrate. While a low ROIC doesn't preclude solid investment performance, the cyclicality and fierce competition of the auto industry do seem to limit company profits and investment prospects.

SEE: Analyzing Operating Margins

The Bottom Line
Even the worst sectors can be home to outperforming stocks, so I would never suggest that investors cannot find a winner or two in the auto sector. In particular, I think companies like BorgWarner are well worth watching as potential long-term investment candidates.

That said, none of the automakers seem especially compelling. Consumers around the globe are seeing renewed financial stress, while those who can buy are demanding better deals and more advanced features and performance. Worse still, many Chinese manufacturers are gearing up to compete in the North American and European markets and leverage their lower production costs. With ongoing intense competition and increasing development costs and requirements, this sector looks like it will continue to face substantial profit pressure for the foreseeable future.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.



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