Auto stocks: Beyond the Big Three
Investor Daily: Automaker stocks may have hit a dead end, but you can find bargains beyond the assembly line.
(Fortune) -- By almost any measure, investors are right to beat up on Detroit. Car sales are at their worst since 1982, credit lines for would-be car buyers remain tight, and the Big Three might as well be called the little three after begging for government help. So the question is: Do auto industry stocks offer investors any value?
The answer is yes. But you have to look beyond limping automakers to their web of large suppliers and dealers, which got socked by fearful investors but nevertheless have diverse businesses and are likely to gain market share when car sales rebound.
As Morningstar analyst David Whiston points out, panicked investors sold off supplier industry stocks when Lehman Brothers' bankruptcy spooked the credit markets - even though car sales had been dismal for a year. Trailing price to earnings ratios for 50 suppliers is 7.6 today compared with a five-year median ratio of 15.4, according to Bloomberg data.
"The fact is that car sales aren't disappearing, even though many companies are priced that way," says Whiston, who recommends looking for suppliers with low or no debt, like Magna International (MGA) and Gentex (GNTX). "Car sales go down, and that ripples through the supply chain."
Investing in downtrodden auto stocks still is risky business. GM (GM, Fortune 500), Ford (F, Fortune 500) or Chrysler could be forced into bankruptcy by a government bailout, in turn decimating many smaller suppliers and even bigger ones. And auto J.D. Power and Associates recently warned a return to normal auto sales could come as late as 2012.
But if you can stomach the volatility and risk, analysts say you should gain long term from other investors' fear. They suggest Tier 1 suppliers - which sell to domestic and foreign automakers - with low debt and diversified businesses that will grow despite poor auto sales.
Ford, for example, announced recently its plan to consolidate its supplier base to 750 from 1,600 in the next few years. Small suppliers heavily dependent on Ford will be hurt. "Consolidation is going to favor bigger players," says Whiston.
One of those bigger, diversified players is BorgWarner (BWA, Fortune 500), a $5.3 billion maker of clutches and turbochargers, which gets just 12% of its revenues from Detroit automakers' North American business. Analyst Michael Ward of Soleil Securities expects BorgWarner's fuel-efficient technology to be in greater demand when auto sales rebound. He points to its turbochargers, which are popular in Europe. They can improve fuel economy by 30% by allowing smaller engines to accelerate as fast as larger ones.
The company's twelve month trailing price to earnings ratio of 7.8, and forward P/E of 10 are below competitors' median forward P/E of 11.6. And its debt-to-capital ratio - an important metric to consider as some suppliers will go bankrupt - is among the best of eight suppliers Ward covers. "It's well positioned to gain after sales come back," he says.
Goldman Sachs analyst Patrick Archambault, who rates BWA a ``buy,'' also favors the company for its low debt and lower forecasted earnings per share declines next year - 11% vs. 31% for its competitors. "We still see BWA as among the best positioned companies in our coverage to weather the downturn in 2009," he wrote in a research note.
Another value bet is the $38 billion giant Johnson Controls (JCI, Fortune 500). Shares of the world's biggest car-seat maker have dropped 49% this year and hovered around a five-year low before rebounding slightly to $18. They now sell for ten times forward earnings.
Johnson, which also makes lithium-ion batteries and car interiors, gets about half its revenues from automakers, down from 70% three years ago. Detroit's North American operations combined for less than 11% of sales last year. That diversification has come from steady growth in its high-efficiency heating and cooling building division - now a $14 billion business and growing. Credit Suisse analyst Christopher Ceraso expects JCI to benefit from that division and a restructuring of its automotive group, with 7,100 employee cuts over two years, while auto sales lag.
"Despite the depressed state of global auto production in 2009, we think the market is unwilling to look out to 2010 just yet to value the automotive stocks," he wrote in a recent report. Ceraso rates shares "Outperform'' and expects a profit recovery in the second half of 2009. Meanwhile, JCI's 3% dividend, which has increased for 33 consecutive years, rewards patient investors.
Auto dealers offer another opportunity to grab beaten-down Detroit stocks. Goldman Sachs analyst Matthew Fassler expects large, publicly traded dealerships like Penske Automotive Group (PAG, Fortune 500) to gain share as high-leveraged, smaller dealerships get squeezed by the downturn. Penske, the second-largest new car seller to AutoNation (AN, Fortune 500), gets 95% of its revenues from foreign brands like Toyota and Mercedes Benz. It trades at an enticing forward price to earnings ratio of 5.5.
Fassler rates PAG a "Buy" and wrote in a recent investor note that the dealer's shares, which are down 62% this year, got caught up in a selloff of retail stocks. But, Fassler said, Penske still has "a high-quality dealer group with a diversified revenue stream, favorable product mix, high-quality management team, and clean balance sheet."
Morningstar's Whiston adds that PAG's portfolio of foreign brands gives investors a hedge against Detroit, which is likely to cut brands and whose dealers have restricted credit the most. "If you're concerned about bankruptcy from Detroit, Penske is one dealer by far that you wouldn't have to worry much about that" he said. Also consider this: 41% of PAG's profit last year came from parts and service repair, which lessens the effect of poor new car sales.
There's still plenty of risk in auto stocks down the line. According to market researcher CNW, car sales stayed depressed for two and three years during recessions in the early 1980s and 1990s. As mentioned earlier, this recession could push recovery well into 2012. And one of the Detroit carmakers could still go bankrupt, spreading chaos throughout the supply chain. But if you buy and hold companies with strong-enough balance sheets to survive even the worst Detroit can offer, you'll speed past a lot of fearful investors.