What to buy, or sell, in the auto sector

Standard and Poor’s Equity Research has a positive fundamental outlook for auto makers. S&P’s Senior Automotive Industry Equity Analyst, Efraim Levy, believes the 2009 second-quarter represented the global industry production and sales trough for the industry. The Toyota brand recall and the absence of a “cash-for-clunkers” program notwithstanding, Levy sees U.S. automotive demand trending higher on a year-over-year basis in the coming months. While Levy expects to see uneven geographic progress, he looks for global demand to rise in 2010, although the pace could be less than previously expected. Also, despite the persistent risks he perceives, including rising raw material costs, Levy forecasts steady improvement overall; second quarter industry profitability was much improved in 2010.

To be sure, despite reduced gasoline prices, economic and employment concerns are keeping consumers out of dealerships and away from buying vehicles. Sales in 2009 were the lowest since 1982. In addition, with reduced credit available for consumers and rising unemployment, U.S. light vehicle sales volume fell 21% to 10.4 million in 2009. However, Levy sees a rebound to 11.5 million in U.S. light vehicle sales in 2010 as well as gains in most other regions. While U.S. demand will remain low by historical standards, overall, we think higher volume in the U.S. and abroad versus 2009 will help corporate profits and cash flows. For 2011, with higher employment and increased consumer confidence expected, Levy looks for U.S. sales volume to rise 13% to about 13.0 million units, as consumers become more confident and employment levels improve.

The termination of most European scrappage programs (the equivalent of the U.S. cash-for-clunkers plan) should hurt European demand in 2010, where General Motors and Ford have a meaningful presence. However, Levy believes other non-U.S. market sales, especially China, will expand and help international profits for 2010. China, the world’s largest automotive market by volume, should continue to contribute to financial improvement to automakers, even as they ramp up investment and face intensified competition, Levy says.

GM and Chrysler have cut and sold product lines and are closing dealerships. Levy thinks there could be improvement in the highly profitable light truck and sport utility segments, especially if the economy and construction and contractor markets improve enough. Luxury vehicle sales, which were also restrained by economic weakness, should show some improvement, in his view.

General Motors and Chrysler have rapidly emerged from their respective bankruptcy filings. GM is now majority owned by the U.S. government, with stakes held by the Canadian government, the UAW, and former GM creditors. It now looks like GM will return to the public markets sooner, rather than later, in a political gift to President Obama. This would allow the federal government to recoup some of its $41 billion remaining investment in GM, according to Levy.

While S&P Equity Research has no recommendation on GM, Levy views the expected IPO as an industry milestone and a confirmation that the government’s investment helped to support the industry during the recent economic crisis. Levy believes there was economic necessity to aid the industry: first, as a buttress to support the U.S. manufacturing and services economy by avoiding the rapid disintegration of the U.S. automotive industry and the broader potential ripple effects during the maelstrom, and second, to position the domestic industry to survive and to benefit from the inevitable U.S. and global recovery in automotive demand. If GM and Chrysler, were not assisted, they would have forfeited to foreign competitors the future profits from higher demand when the industry recovered, Levy thinks. Now, regardless of the ultimate resolution of the automakers’ status, they will have had the opportunity to participate in the global recovery, Levy says. While these reasons, Levy believes, would have sufficed to justify the bailouts, he believes the U.S. and Canadian governments’ opportunities to recover a significant portion of taxpayer investments and the possibility of even reaping profits vindicate the actions.

Chrysler is now controlled by Fiat SpA of Italy and also owned by the UAW and the U.S. government. The bankruptcy filings have allowed the automakers to shed billions of dollars in liabilities, sharply reduce the number of dealerships as well as decrease their operating costs. Overall, S&P believes this makes the companies more cost competitive and focused.

Ford, the sole U.S. automaker not to file for bankruptcy code protection, has been gaining U.S. market share. Levy believes it benefited, in consumers’ eyes, from not accepting government aid and from timely and well accepted new products. It has also benefited from quality issues at Toyota, while improving its own reputation with consumers.

Refocused and leaner American car markers still face challenges from rivals, says Levy. The Japanese automakers makers remain competitive and the Korean’s car makers are surging in the United States, he says. Looking to the future, he forecasts, it’s not hard to see Chinese and Indian competitors on the horizon.

Levy has a buy opinion on Toyota and hold opinions on Ford, Honda, and Nissan.

S&P employs a proprietary methodology for ranking mutual funds and exchange-traded funds (ETFs); rather than looking only at past performance, S&P also incorporates analysis of the underlying holdings and their likely future prospects, as well as risks and costs. Funds or ETFs that hold stocks viewed as undervalued by S&P equity analysts are more likely to get a high ranking from S&P’s proprietary quantitative ranking tool.

Indeed, several mutual funds hold Toyota Motor as a top-ten holding, and garner a high score in S&P’s ranking, which ranges from five-star (best) to one-star (worst).

Similarly, two ETFs hold Toyota Motor as a top-ten holding, and garner an “overweight” ranking from S&P.

To get access to Standard & Poor’s Equity Research go to www.getmarketscope.com, or call 1-877-219-1247, or send an email to [email protected].

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