By Efraim Levy
After making history in 2000, the U.S. auto industry was due for a letdown. And while sales volumes were strong in 2001 -- in the midst of a volatile year -- they remained below the record shipments of the preceding year.
The stocks of the largest players in the U.S. auto market, the "Big Three" domestic automakers (General Motors, Ford, and DaimlerChrysler's Chrysler division), put in a mixed performance in 2001. The S&P Automobiles Index, consisting of General Motors and Ford, fell 23% through December 20, dragged down by a 33% drop in Ford shares.
The group's decline largely reflected lower profitability, shrinking market share, and the anticipation of lower sales in 2002. But other, more company-specific factors came into play. Ford suffered its first back-to-back quarterly operating losses in about a decade amid continued tire recall troubles and other quality and competitive issues. Chrysler's red ink continued as it slogged through a massive restructuring of its operations. These two companies will likely expand existing restructuring activities in 2002.
The one bright spot among the domestic automakers has been GM. Despite lower profitability, GM has stabilized its U.S. market share losses and improved its product mix with a bevy of well-received light trucks. But it still faces stiff competition and pressure on margins.
In a nutshell, it has been a difficult year for investors in the automobile industry. The big questions now: What's ahead for automakers in 2002? And what should an investor do?
BUY AT THE BOTTOM.
Normally, the best time to purchase auto companies is when things look really bleak: after a bottom in demand has formed; vehicle shipment volume has dropped; revenues have plunged; manufacturers are bleeding red ink; and cash is running out the door. In addition, price-to-earnings ratios seem exorbitant (because the multiple is based on a tiny profit figure) or non-existent (there's no p-e to speak of if the company has posted a loss).
That's precisely when you want to put your money to work -- in anticipation of a cyclical rebound. If you wait until sales really do start climbing and companies start reporting profits again, the biggest gains may have already been made.
Conversely, traders should sell when sales and profits are booming and valuations appear cheap. Investors may start selling in anticipation of a downturn after a peak.
S&P predicts record U.S. light vehicle sales volume of approximately 16.9 million units in 2001 before a decline to 15.8 million vehicles in 2002. Automakers' shares have already fallen in anticipation of reduced sales and weak profitability, and they may have farther to fall.
The Big Three should see greater than industry average volume declines as foreign carmakers continue to gain market share. Through November, the Big Three saw their collective share of U.S. light vehicle sales fall 2.4% to 64.7% in 2001. We expect further market share erosion in 2002.
Who will gain as Detroit falters? Driven by new and popular products, Toyota Motor Corp.'s U.S. market share may continue to gain on Chrysler's tally as the smallest of the Big Three focuses on margins over market share as it struggles to regain profitability. Korean manufacturers in particular of have shown renewed strength, primarily in the low-end sedan market.
Of special concern for Detroit, however, is the highly profitable light truck, minivan and sport utility segment. That market is facing increasing pricing pressure now that the Big Three's dominance is waning. European and Asian manufacturers have started to have success in this market and will further target this segment with new offerings. As a result, margins will come down for all the participants.
One other worry for the Big Three: Rising sales of luxury import models are also hurting domestic manufacturers' margins in the lucrative luxury vehicle category.
ALL IN THE TIMING.
When to get back in to auto shares? It's hard to tell. Auto sales in recent years have defied forecasters with unusually robust sales over an extended period of time –- and now it may be payback time on the downside, especially after 0.0% financing programs dragged early 2002 sales into 2001. Other factors restraining demand include a soft economy, rising unemployment and lower stock prices, all of which have contributed to reduced consumer confidence.
Lower demand (though still strong by historic standards) for automobiles could have a ripple effect on the broader economy, further slowing down demand and pushing out a recovery. If it does, a rebound in auto demand in the second half of 2002 is possible; aggressive investors may want to get in before this becomes obvious to all, possibly in the second quarter. But S&P doesn't expect auto stocks to outperform the market in the early part of the year.
While Ford has announced reductions in its planned production for the first quarter, GM will increase production to fill depleted inventory. Lower production equals lower sales, and with laid-off line employees eligible for 95% of their regular paychecks, the savings are not very large. However, production cuts would allow manufacturers to keep their inventories at reasonable levels should demand drop off as we expect. Pressure on margins and profits remain a concern. In this environment earnings estimates can change frequently -- and precipitously.
For the long term, we are concerned about the Big Three. Competition is intensifying, especially in the highly profitable light truck segment. Their profits are likely to shrink as competition reduces sales volume and margins per light truck as pricing power weakens. Our investment opinion on these shares reflects our concerns: DaimlerChrysler (DCX ) and Ford (F ) each carry an S&P ranking of 3 STARS (hold), while General Motors (GM ) is ranked 2 STARS (avoid).
And so while shares of the Big Three are well off their highs, and could rebound from yearend tax-related selling, with the risk of a sharp slump in near term demand, we believe caution and patience are virtues for prospective investors.
Levy is an equity analyst covering the auto industry for Standard & Poor's