An Investigation Into the Relative Cheapness of the Automotive Industry

April 21, 2016

An Investigation Into the Relative Cheapness of the Automotive Industry

  • With a PE ratio of 5 to 10 the automotive industry looks attractive
  • The risks are that the industry is considered to be at a historical peak by most analysts
  • A global perspective gives a bullish outlook for the industry

Introduction

The automotive industry is usually called a cyclical industry, considered elastic in relation to GDP and vulnerable to economic shocks. According to a former Ford chief economist a normal recession reduces sales by 15%. With sales being reduced by 15% and costs being inelastic the decline in sales is the one that makes the difference between strong earnings and big losses. Any sign of a recession puts people off from buying new cars and makes them stick to the car they have for a little longer. Connecting the cyclicality and cost inelasticity with the current valuation for automotive companies brings to interesting conclusions.

Automotive Valuation

The current valuation of the 10 biggest automotive corporations is really cheap. In the below table most companies have a PE ratio between 5 and 10. Fiat-Chrysler has PE ratio of 31.8 but adjusted earnings are much better due to a one-off charge of €830 million for the realignment of their US production which brings to a forward PE ratio of 5.1. Tesla is included in order to show how a positive sentiment can easily influence valuations in a completely opposite way than the industry standard.

Screen Shot 2016-04-20 at 4.22.17 PM

Figure 1: Automotive valuation. Source: Morningstar.

A PE ratio in the range of 5 to 10 when compared to the S&P 500 average 24.25 almost suggests that the car industry is about to go belly up. Even oil companies, that have witnessed severe declines in oil prices and revenues have better multiples, Exxon Mobil has a PE ratio of 22.3 and Chevron has 40. Most of the automotive companies trade at prices lower than their book value and price to sales ratios are also much lower than the S&P 500 average of 1.86. In order for the automotive industry to be valued similarly to the S&P 500 their prices should increase at least two fold and for some three fold. The low valuation suggests that there are some short to medium term negative factors expected for the industry.

Potential Issues

One of the potential issues that put off investors from paying higher multiples could be the expectation of higher interest rates. Higher interest rates, not only make it more expensive to pay for the debt the

GDP

Figure 2 U.S. gross domestic product in billions of dollars. Source: CBPP.

companies hold but also make buying a car more expensive for customers as up to 85% of new car purchases are financed.

Another issue could be the expectation of a recession. US jobs data is showing the first signs of topping out. Usually the job market peaks prior to recessions when the actual GDP surpasses the potential GDP and there is full employment.

Product recalls and regulatory issues also represent a big risk. Such news usually come as a surprise and have a large effect. The Volkswagen scandal of last September is a perfect example of that. But maybe all those potential bad effects are already priced in seeing the low stock valuations.

The most pessimistic analyst for the auto industry is Max Warburton from Bernstein Research who summarizes the above with the statement that:

“Buying autos this late in the global economic cycle is arguably dangerous–precedents suggest the sector usually delivers most of its performance early in the cycle.”

On the other hand, Warburton is mostly focusing on the US while the source of the bullishness for the automotive industry lies in emerging markets.

A Bullish Outlook

Increased interest rates and recession risks are lower than they were 20 or 30 years ago because the automotive industry has become a global one and is not confined to anymore to Europe and North America.

vehichle sales per region

Figure 3: Global automotive sales forecast by region. Source: Statista.

Sales in North America and Western Europe look stable and constant in the last 20 years but sales in Asia show huge growth. The global sales diversification from 1999 when more than 75% of car sales were made in North America or Western Europe to today’s numbers where about 50% of sales come from China and other Asia show how car companies have become globally diversified and increases in US interest rates or a US recession would have an impact but not as strong as it used to have in the past.
cars gsp

Figure 4: Cars per 1,000 people in relation to GDP. Source: MDPI.

A positive long term catalyst is the still huge growth potential car companies have in Asia, South America and Africa.

In order to reach saturation levels like in Western Europe or North America the Asian market has still to grow more than 10 fold. This would mean global car sales would be at least double the current in a conservative estimation. Of course, the living habits and infrastructural possibilities in Asia are far from the ones in the West but the above chart shows how big is the automotive industry potential.

The Tesla Craze

Tesla is often called the “big disruptor” in the industry with the hope that electric cars will take over the world and Tesla will be the leader. Well, reality is far from that. The recently announced Model 3 deliveries will start only in late 2017 and the profitability of it is highly questionable seeing that the Model 3 is similar to the current Model S and Tesla is currently losing $18,331 per sold car. On the other hand, Chevrolet, part of the GM group, will start delivering Chevrolet Bolt by the end of 2016 with more than 200 miles of range and for a price around $30,000. Other competitors with much more experience and better cost efficiency than Tesla are also entering the electric market. For example, by the end of this year Hyundai should introduce its electric vehicle, Ioniq.

Conclusion

Companies with PE ratios from 5 to 10 with positive future global growth prospects seem a crazy idea. But, historical perceptions of the risks related to the automotive industry keep their valuations low and provide investing opportunities. Regional recessions or interest rate increases should be offset by emerging markets growth in the increasingly global automotive market. The speed at which old car companies adapt to new technologies like electric vehicles and unlike new competitors (Tesla) manage to be profitable show that it is better to stick to the old dogs in this case because they are fast in learning new tricks and manage to keep the old fashion profitability. Due to the above mentioned risks every investor should assess his own tolerance for cyclicality but the current yields are very tempting.