Gearing up on Honda stock

Analysts say the Japanese automaker should weather the slump and pick up speed when the economy bounces back.

By Katie Benner, writer-reporter

NEW YORK (Fortune) -- With consumer spending weak and America's auto industry in shambles, automakers sure don't hold a lot of investment appeal these days.

But now might be a good time to look beyond Detroit and kick the tires on Honda, which makes some of the world's most popular small cars.

Analysts believe the Japanese company's reputation for quality and its strong balance sheet should let it weather the current downturn and increase market share once consumers start buying big ticket items again. Government aid programs in the U.S. and Japan should also help it manage during the slump.

No car manufacturer was able to cut costs fast enough to keep up with the downturn, but Honda still managed to surprise Wall Street with a better-than-expected operating profit in 2008. Analysts expect earnings to grow by more than 20% over the next five years, according to Zack's Investment Research.

The company also has little debt and a strong A+ credit rating, which means it should have little problem raising money if the downturn continues to squeeze profit margins.

Honda (HMC) shares trades at a forward P/E ratio of 20. That's a considerable premium to most of its competitors, but keep in mind -- few car companies reported any earnings at all in 2008. Its stock is about 22% off its 52-week high set in September of 2008, but it's climbed more than 18% year to date.

If you look under Honda's hood, you can see why the company has a higher market value than its peers -- even over top carmaker Toyota. Honda has long focused on small, fuel-efficient cars, while its Civic and Accord are consistently top sellers with high resale values, according to JD Power and Associates.

Morningstar auto analyst David Whiston says Honda's sales mix gives it an advantage as the critical U.S. market undergoes "a structural shift away from gas-guzzling pick-ups and SUVs, and toward Honda's vehicle-making expertise."

Toyota, on the other hand, has built its franchise on its high-margin luxury Lexus line and light trucks, according to research from Credit Suisse, which says the company would have to increase sales for those vehicles and dramatically cut costs in order to sustain earnings. Few doubt that Toyota will achieve those goals, but most analysts believe Honda will be able to cut costs faster and is already focused on selling the cars people want to drive.

"Honda has an advantage because it never went into large vehicles," says Whiston. "Toyota did and now may scale back on those plans. Honda has also successfully avoided offering incentives to sell cars, which helps preserve resale value. Toyota has recently begun offering those incentives."

And the effects of the financial crisis will be smaller at Honda than at its peers because of "the virtual absence of full-sized pickups or other large vehicles in its model lineup, the relative strength of its motorcycles business, and expanded sales of new cars in Japan," writes Barclays analyst Tsuyoshi Mochimaru in a July note. Toyota has long been committed to not laying workers off, Whiston adds, giving Honda more flexibility to implement drastic restructuring plans if the U.S. auto market deteriorates even further.

Government efforts to prop up auto sales and push fuel-efficient cars may also help Honda. The House recently passed a bill to offer vouchers worth up to $4,500 that consumers could use to help pay for more fuel efficient vehicles. The bipartisan measure is expected to spur up to 1 million sales over the course of a year.

Moreover, the Obama administration plans to implement fuel efficiency standards of 35.5 miles per gallon by 2016. According to PricewaterhouseCoopers auto research center, this should boost sales for cars with smaller engines, direct fuel injection, and electric vehicles, whether they be hybrid, pure electric, or plug-in. Among the leaders in these fields: Toyota and Honda.

Honda is also taking direct aim at Toyota's hybrid vehicle dominance. Hybrids account for only about 2.5% of U.S. auto sales, but it is a quickly growing segment. Toyota's Prius accounts for more than 50% of those sales.

Honda recently introduced the low-cost Insight hybrid vehicle to gain a foothold in that small, growing market, and it plans to rollout a total of four hybrids by 2015, including a hybrid model of the Civic, which could help the world's ninth-largest automaker by sales rise up a notch or two.

Editor's note: An earlier version of this story incorrectly stated that Barclays analyst Tsuyoshi Mochimaru said the effects of the financial crisis will be smaller at Honda because, unlike Toyota, it's not committed to avoiding layoffs. That statement was made by Morningstar analyst David Whiston.  To top of page

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