A sales boom is lifting this once-loathed sector

Auto industry shares are rallying but still have abundant upside. Here's why.

By StreetAuthority Jun 6, 2013 4:56PM
By David Sterman                                                       

Four years ago, anxious policymakers in Washington threw automakers a badly-needed life line. The  "cash for clunkers"  program, which bribed people into buying new cars, helped stave off a death spiral that had beset the auto industry.
Yet just four years later, few people even think about "cash for clunkers" anymore. Sales trends for the major automakers (and their parts suppliers) are now booming, and it's easy to see how trends will get even stronger from here. Within a few years, sales trends are likely to meet or exceed the previous annual peaks, and share prices in this sector now have upward of 50% upside.
The Long Climb Back
In the middle of the past decade, the auto industry sold roughly 16 million to 17 million cars and trucks annually in North America. That figure slumped to just 10.4 million in 2009 but had rebounded to 14.4 million in 2012. This year, that figure is expected to be about 15.4 million.

Yet according to analysts at Merrill Lynch, there are four factors in place to suggest that this figure will hit 18 million in the next five years. These factors include:

Image: Row of cars in car lot © fotog, Tetra images, Getty ImagesCurrent sales levels are still below the replacement rate, meaning the average age of cars on the road continues to climb higher, recently hitting an industry record 10.6 years.
Automakers are on the cusp of their most aggressive new vehicle launch program in memory.

"This wave of fresh product will likely stimulate demand and get consumers into showrooms, especially as automakers continue to pick up marketing spending," noted Merrill's analysts. Ford (F) and GM (GM) have the most aggressive product cycle refresh plans in the industry over the next three years, more than any major Japanese, European or Korean automaker. And as Merrill's analysts note, "Replacement rates drive market share."

Financing rates should remain very low, as it will likely be several years before the Federal Reserve hikes the rates that determine auto loan rates. Moreover, dealers are noting much easier access to credit for most applicants than a few years ago.

An eventual rebound in new home construction (which has its own set of pent-up demand factors) should trigger a rising wave of high-margin pickup truck sales. (Notably, pickup truck sales rose roughly 25% in May for the three U.S. automakers, compared with a year ago, and that spurt comes before any major upturn in new home construction has begun.)

If the industry indeed sells 15.4 million units this year, the move up to 18 million in five years represents growth of 15% to 20% from current levels, which may not seem like much. But the fixed costs in the auto industry are so high that those incremental sales carry far higher variable margins than the profit swing that automakers saw from 12.7 million units in 2011 to the current sales volumes.

Another factor many overlook is sharply falling labor costs. The average auto worker now makes around $55 to $60 an hour in wages and benefits, down from $75 in 2007. Moreover, advancing technology has increased assembly-line automation, which means more autos are being made with fewer workers.

Lastly, industry capacity is now 15% lower than in 2007, which means the industry will have solid pricing power as volumes rise and won't have to resort to the hefty rebates that once bedeviled this industry.

The Profit Impact
Despite the emerging boom in the North American market, the European market still stinks. Ford, GM and others are bleeding cash there.

That's why Ford, for instance, is seeing near-term earnings per share (EPS) forecasts stuck near $1.50 a share. If we were talking solely about the North American market, and Ford were simply to retain constant market share in a market that rises to 18 million units, we would likely be talking about EPS in excess of $2.50 and perhaps approaching $3.

Will Ford and others keep hemorrhaging cash in Europe? All the major automakers are belatedly tackling their cost structure in Europe, and break-even results could appear as soon as next year or 2015. That should help investors focus again on the stunning levels of profitability in the North American market.

Might the region eventually be a source of profits? Analysts at Sterne Agee think European auto sales will bottom out this year at 16.9 million units and rebound to 17.5 million units by 2015. At that level, modest profits -- instead of open-ended losses -- may become the norm.

What Kind Of Upside?
Roughly six weeks ago, I looked at whether Ford or GM was the better investment.

I gave the slight edge to Ford (and its shares have subsequently risen close to 25%), yet also noted great appeal in GM's shares and that stock has risen about 20% (against a 5% gain for the S&P 500).

Yet with a view toward 18 million vehicles sold annually by 2018, the upside remains robust. There is a wide variety of metrics with which to value these stocks, with many focusing on earnings before interest, taxes, depreciation and amortization (EBITDA) in the context of enterprise value. In this instance, I prefer a straight-ahead price-to-earnings (P/E) ratio approach.

The prospects for $3 per share in profits for Ford within a few years are taking shape, and if you assign a multiple of $8 to that figure, you get to $24 (50% upside). GM is likely to earn around $3.40 a share this year, but with a growing U.S. market and shrinking losses in Europe, that figure looks set rise at a robust pace.

Credit Suisse analyst Chris Ceraso wrote that "by making reasonable assumptions regarding regional sales, market share and earnings before interest and taxes (EBIT) margins, we see 2015 earnings in the $5 range as very achievable, with potential upside toward $6 by 2016 should GM deliver on its mid-decade margin targets." Assuming $5.50 in EPS by 2016 and applying the same multiple gets us to $44 a share, which is roughly 30% above current levels.

Risks to Consider: Though the U.S. consumer appears increasingly confident, an economic slowdown would derail the auto industry's recovery -- as potential new car buyers grow skittish. Moreover, the bright outlook for automakers is partially based on an upturn in new home construction, which may or may not come to pass.

Action to Take: The charm of these auto stocks is that even after solid gains in recent months, they have so much upside left simply because they were so utterly cheap in 2012.

This same logic can be applied to the auto parts suppliers, many of which also have much stronger balance sheets, much lower labor costs, and are leveraged to yet higher profit margins as industry volumes rise. A few months ago, I noted these firms were in a position to be key players on the current mania for stock buybacks, which could radically reduce their share counts and pump up earnings per share.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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