Equities: The Automobile Industry Under Transformation

Over the past few years, the automobile industry has been driven by a succession of significant events: the diesel scandal, technology innovations, and more recently, fears of the return of protectionism.  In this changing environment, automakers are managing (more or less) to navigate through this increasingly complex environment.

The automobile sector has perked up since its 2016 low. Being highly cyclical, it has fully benefited from the reflation trade in developed countries and the sales recovery, particularly in China. Despite this rebound, the sector is still trading at very attractive valuation levels in Europe. The price-to-earnings ratio is now less than 8, well below its historical average.

These low valuations may seem attractive at a time when buy opportunities are rare on overbought stock markets. However, valuations aside, relatively well-informed investors must be aware of several characteristics of the automobile industry.

UNSYNCHRONISED CYCLES BETWEEN GEOGRAPHIES

The sales cycle is mature in both the US and the UK.  The more upbeat economic climate (recovery in employment, rise in consumption and low interest rates) has underpinned the bullish sales trend since 2010. Today, vehicle sales tend to be shrinking in the US, discounts on new cars are as high as 12% and the stock of vehicles has edged up. Moreover, the stock in the US has been largely replaced in recent years while used cars prices (albeit not collapsing) are falling and progressively moving away from their 2016 highs.  This price decline is altering leasing conditions while pushing down the residual value of cars. In addition, it is a risk for loans when the due amount is higher than the value of the car (“negative equity position”). Some commentators are now concerned about the record level of auto loans and their concentration in US banks. Numerous risky (“subprime”) loans have been granted in a favourable economic climate. They have been rising constantly over the past three years, accounting for nearly 11% of US auto loans today. The volume of loan defaults—albeit increasing—remains at acceptable levels, but it may rise in the event of an economic reversal. The most exposed stocks in the US equities market are the “Big Three” (GM, Ford and Fiat-Chrysler) and Toyota.

However, the upturn in the eurozone auto market occurred later (in 2014), as the region was less advanced in the economic cycle. The European market has long been penalised by the 2008 financial crisis, and then the euro crisis in 2011, squeezing the purchasing power of European consumers who tend to postpone their purchases. Consequently, Europe’s vehicle fleet is fairly old, especially in Italy, Spain and France. In view of the expected (albeit gradual) improvement in domestic demand, sales are set to continue to rise. Stocks exposed to the Continental European market (PSA, Renault, VW) appear to be benefiting most from this renewed interest.  

Turning to emerging economies, visibility on the Chinese economy remains key for car manufacturers. In the coming years, sales might well decline in China. The tax implications will be less favourable in the near term. Concerned about an economic slowdown occurring in 2015, the Chinese government decided to bolster growth in the automobile market by cutting taxes between October of that year and December 2016, a measure which had a positive impact on sales (+15% in 2016). Now that these tax breaks have been removed, sales growth in 2017 should be logically slower.  The compound annual growth rate (CAGR) is expected at nearly 5% (vs. 10% between 2011 and 2015). However, the craze for SUVs (sport utility vehicles) should continue to be a good market for auto manufacturers. Today SUV sales account for 40% of total vehicle sales in China (vs. 10% in 2010). Similarly, sales of premium vehicles (e.g. Mercedes, Jaguar, BMW) remain solid today and the potential sales penetration rate is still high.

No emerging market is as mature as China. Growth in the Indian market remains robust (+7% in 2016) thanks to a good economic environment. Furthermore, certain emerging markets foresee a recovery in their respective local markets. Brazil and Russia could offer attractive growth drivers following a year of economic recession. This is already the case in Russia where sales are starting to pick up (+9% y/y in March 2017) while sales are still sluggish in Brazil.

IN EUROPE, THE EVOLUTION OF EXCHANGE RATES IS KEY

The euro has appreciated sharply in recent weeks. Being large exporters, European carmakers are particularly sensitive to currency movements. A fall in the euro would be excellent news for the majority of them.

STRUCTURAL CHANGES: THREATS OR OPPORTUNITIES?

The automobile industry must also undergo major structural transformations: 

Ecological and energy issues are vital. Despite President Trump’s decision to exit the Paris climate agreement, most political leaders are sticking to their targets for reducing carbon emissions. More importantly, automakers have already anticipated legislation changes by including eco-friendly measures in their investment decisions. This determination to cut greenhouse emissions is forcing automakers to adapt their range of vehicles. Since the Volkswagen scandal, an emerging sector trend is that diesel cars have been gradually losing ground (56% of total demand for cars in Europe in 2011, vs. 49% in 2016) to petrol cars, but also to hybrid cars which are less economical. Lastly, electric cars open up long-term questions and require huge R&D expenditure. That said, projects for electric cars are multiplying worldwide including in China (e.g. NextEV). Their profitability will depend on the cost of electric batteries and the development of infrastructure.

Going forward, it is essential that incumbent car manufacturers manage these changes. But governments also need to play their part as they view the industry as a source of future economic growth and employment.

New technologies are transforming the industry.

The most promising innovations (software, internet and big data) are created by technology companies which are not part of the automobile industry’s conventional ecosystem. Driver assistance, autonomous vehicles and connected cars are just some of the challenges facing automakers these days. According to PricewaterhouseCoopers, an accounting firm, electronic components will represent nearly half the total cost of a vehicle by 2030 (vs. 30% today). In this context, new market entrants are tech giants (e.g. Apple) which are eyeing the automobile market. In other words, it is imperative that carmakers adapt to this new disruptive competition.

Consumer trends are changing. The use of shared cars in towns and cities and electric cars coupled with the boom in SUVs are clearing having an impact on auto sales.   

These technology transformations are creating new opportunities for automakers. However, in the context of ever-changing innovations, success is not guaranteed.  On the other hand, tech companies (particularly semi-conductors) have industry expertise and benefit from the same boom in electronic components in the manufacturing industry and consumer goods. They are therefore the big winners of the changes taking place in the automobile sector today.