It's Time to Buy America's "Big 3"

Will is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Home to the Bad Boys, Smokey Robinson, and the 11-time Stanley Cup Champion Redwings, Detroit will always be famous for one thing: cars. For years, the dominance of the “Big 3”—Ford (NYSE: F), General Motors (NYSE: GM), and Chrysler—helped power a Midwestern city with little else to its economic name.

Of course, the 2008 crisis highlighted how much the times have changed, but an impressive recovery has put all three companies back in the national conversation. Now, especially as automakers fall victim to macro concerns, it looks like a time to buy the Big 3 again.

Promising play

The company opened a $500 million plant in China earlier this month, doubling production capacity in an effort to keep up with rapid demand. In May, Ford sold 70,540 vehicles in China, an increase of 45% against the previous year—three times the rate of the company’s domestic growth. Asia currently sits at nearly 20% of Ford’s market, so doubling production in China could help Ford to sustain that impressive growth.

A recent string of recalls brought the question of quality back to mind, at least in North America, which is a concern given that the continent amounts for almost half of Ford’s sales. But the U.S. still saw 14% year-over-year growth in May; quality is a currently a concern, not an issue. What’s more, Ford trades at just over 10 times earnings, much less than the industry average of 14.5 or the S&P 500 average of 16.9. Ford’s 2% dividend (nearly twice the industry average), makes it look even more promising.

Making progress

General Motors is better than Ford at almost everything, except for one, key component: making money. Even though its current operating margin of almost -20% is exaggerated because of deprecation costs in Q4 2012, the company’s 2011 mark of almost 3% needs improvement. Last week, the company highlighted enormous progress in its plans to do just that. GM now hopes that 96% of volume will be on 13 core architectures, and already has reached 71% volume on those architectures against just 31% in 2011.

In other words, GM will cut costs by condensing its sales into a few, profitable product lines, thus allowing the company to capitalize on “economy of scale.” Like Ford, GM’s P/E looks better than the industry average (8.0 against 14.2), and while it does not offer a dividend, GM also boasts an EPS of over 3 (trailing-12 months of 4.2), which suggests that the company will eventually generate income to investors regardless of when—or if—it instigates a dividend.

Indirect exposure

It’s actually impossible to invest in Chrysler directly, but investors can still invest in the company indirectly: through Italian automaker Fiat (ADR) (NASDAQOTH: FIATY.PK) or German automaker Daimler (NASDAQOTH: DDAIF.PK), both part-owners of Chrysler (along with private company Chrysler Group). The company reported its best month since 2007 last May, when vehicle sales grew 11% to 166,596 units—this after an impressive 2012 that saw operating profit grow 47% to $2.9 billion.

The company seems prepared to sustain earnings well into the future, which bodes well for both Fiat and Daimler AG. Fiat already trades at a value equal to its current cash flows. In other words, the stock price is equivalent to the amount of money that the company earns without accounting for appreciation, while the industry on average trades at seven times that cash flow.[1]

Meanwhile, Daimler AG, which owns Mercedes-Benz, operates with a trusted brand that people not only know, but demand, helping the company to approach record numbers in the face of a struggling luxury vehicle environment. The impact of Chrysler’s growth is marginalized, but both companies look like solid buys regardless.

Bear case

As always, a bear case exists. Automakers will be susceptible to global macroeconomic trends, on the one hand, and at least some people believe that the stock market is currently overpriced. This suggests that prices may fall regardless of whether Ford, GM and Chrysler consistently earn money. However, to the investor that takes a long-term approach, one thing is clear: the stock prices of the Big 3 (or, in Chrysler’s case, the publicly traded companies that are affected by it) do not reflect the real value of those companies.

Bottom line

For many years, Detroit automakers drove Detroit on the idea of supplying America with cars. The Big 3 might never again be “The Big 3,” but that doesn’t mean they can’t reinvent themselves, perhaps as global players in a variety of markets. But regardless of how they earn the money, they certainly seem prepared to do so well into the foreseeable future.

[1] Many analysts would say that it is better to analyze foreign companies from a price/cash flow standpoint than a P/E multiplier, due to different accounting standards in different countries.

Will Chavey has a position in Ford. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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