Find Safety in the Auto Sector with GM, Johnson Controls

By Bill Edson - July 23, 2012 | Tickers: F, GM, JCI | 0 Comments

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Automakers and supporting auto-industry companies have been treacherous investments. General Motors (NYSE: GM) went bankrupt, and there have been multiple bailouts for US firms in recent history. There are matching positive qualitative forces which might overwhelm some of the doom and gloom, which ultimately means that investors should exercise discretion when picking auto stocks. Below, I will show why General Motors and Johnson Controls (NYSE: JCI) are two safe stocks to consider in the auto sector right now.

Doom and Gloom

There are many reasons why investors should be weary of firms that supply parts for cars, manufacture cars, sell cars, or service cars:

Bankruptcy often is a revolving door. Don't for one second think that an arbitrated default makes an industry outlook any brighter. Most bankruptcies and other business failures happen when mediocre firms find themselves in difficult situations. A bankruptcy and a change in management or ownership does not make an economic environment less challenging. The operations, assets, and challenges are the same, regardless of ownership.

Older people buy fewer cars. US and advanced economy demographics do not bode well for automakers. Retirees have almost nowhere to go and therefore tend to put less mileage on their cars per year. Thus, their cars deteriorate less and they can wait longer between purchases. Moreover, retirees who still drive tend to have fewer lifestyle changes than the general population. They are less likely to buy a smaller car for city driving and parking and are less likely to buy a larger minivan for the kids. They are more set in their lifestyles. Worst of all, many old people are unable to drive. Thus, they are less likely to buy new cars for themselves if they need a chauffeur.

US manufacturing is expensive. I hate to vilify unions, but autoworkers get paid very well compared to employees in other industries with similar levels of education and experience. The strength of auto labor unions in the United States is a competitive disadvantage for auto firms in the United States.

Automakers are highly regulated. They must meet government safety standards and often must recall autos for expensive repairs. Yes, recalls still happen. For example, starting July 23rd, Ford (NYSE: F) will be recalling its 2013 Escape SUV's due to a problem with the carpeting on the driver's side of the car. Ford determined through internal tests that the carpet could block the brake pedal, inhibiting the car's braking capacity. The carpet can also get in the way of moving from the accelerator to the brake pedal. Ford will be replacing the carpet with a console trim panel for free, recalling more than 10,000 SUVs across the US, Canada, and Mexico. If carpeting can cause a recall, anything can.

Signs of Life

There are many qualitative factors which bode well for automakers:

Bailouts and other government subsidies. First and foremost, US government support seems to be a foregone conclusion at this point. Recently, the US Treasury Department has offered loans with low rates to car companies like Ford and Nissan (NSANY) to get them to develop eco-friendly cars that are electric or fuel-efficient. Instead of incentivizing buyers to buy such cars by offering them a tax break or some other monetary encouragement, the US government has guaranteed loans now equaling up to $8.4 billion and are guaranteed for up to 30 years to major car companies that have the capacity to finance themselves in the free market. While Ford is taking the bait by taking out a $148 million loan with 1.3% interest, using it for things like updating US auto plants, Ford definitely does not need a helping hand anymore like it did during the recession when private financing was scarce. Ford's credit rating is now investment grade, and in June Ford sold $1.5 billion worth of unsecured five-year notes.

Growing foreign markets. Foreign demand is also cited as a savior of US automakers. General Motors is expecting its sales in Saudi Arabia to rise due to the high demand for SUV's and the cheap price of gas in this Islamic country. GM is expanding to 142 showrooms by 2014, a 29% increase encouraged by the 26% rise in sales through May. GM will be facing new competition; however, as Saudi Arabia is branching out of its market beyond oil by developing its own luxury SUV made for travel in the desert.

Valuation and Leverage

Consider the following financial metrics for auto industry stocks:

We can use debt-to-equity as a crude measure of balance sheet risk and the three valuation ratios listed, price-to-earnings, price-to-sales, and price-to-book to determine how richly the stock is valued. From this table it is clear that AutoZone is overpriced based on its negative equity (liabilities are greater than assets on the balance sheet). Its price-to-earnings ratio and its price-to-sales ratios are higher than most of the other stocks in this table despite this weakness.

Ford also has a precarious balance sheet, with six times as much debt as it has equity. Fortunately, it is also very cheap. Its rock-bottom price-to-earnings and price-to-sales ratio demonstrate how the market is pricing this stock as a speculative play. Don't bet the farm on Ford, but it is worth a look as a very small, speculative bet in your portfolio.

Two safer bets are General Motors and Johnson Controls, both of which trade at attractive price-to-sales ratios and price-to-earnings ratios. Investors seeking exposure to the auto industry should begin by investigating these two firms, both of which have sensible levels of debt while trading at reasonable prices.

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