Moats, Motors, and Markets in 2020

Because some of our most high-profile automotive names, such as General Motors GM and Ford F, do not have an economic moat, investors may assume that the entire auto industry is low quality, but we disagree. Suppliers often have moats from several sources in our moat framework, particularly intangible assets and switching costs, based on factors such as the long-term relationships with automakers that lead to win rates of 90% or higher on a new generation of a vehicle that the supplier already services. Some automakers we cover, such as Ferrari RACE/RACE, even earn a wide moat around the intangible asset of their brands’ pricing power.

That said, we have long argued that a no-moat company and a cheap stock are not mutually exclusive. We reiterate that view with no-moat GM, which is in the midst of a cost-saving plan that we think could increase its adjusted automotive free cash flow to the vicinity of $10 billion in some years after 2020, up from pre-UAW strike guidance for 2019 of $4.5 billion-$6.0 billion and $6.0 billion-$7.5 billion guided for 2020. For investors preferring a moat, BMW BMW/BMWYY and Adient ADNT, as well as leading turbocharger maker BorgWarner BWA, offer good value, in our opinion, all with narrow moat ratings. Adient is the leading seating supplier and is going through a major restructuring, so we think the stock is only for the most patient investors. Still, we think that the current valuation is nonsensical and that the stock is a tremendous bargain.

We forecast 2020 global light-vehicle demand to be up 1% to down 2%. Risks to our forecast include an incorrect assumption by us that the U.S. economy remains healthy this year, Europe does not severely worsen from present levels because of Brexit or a U.S. trade war, and China recovers following a poor 2019. We think the U.S. market will soften by about 3% from 2019 as continued elevated off-lease supply compared with a few years ago drives more consumers into used vehicles over new. In Europe, in our base case, we look for 2020 to be flat to down 2% on slightly softer economic conditions, while a hard Brexit could result in a market that declines roughly 20%. We are more aggressive than some other forecasts for China with about a mid-single-digit increase as gains in personal income and more middle-class consumers, along with a low base in 2019, enable growth in 2020. Japan declines 5%-7% on higher value-added tax. Brazil continues to recover with an 8%-10% increase, building on it 8% increase in 2019. After declining 12% in 2019, India establishes a trough in 2020 with a flat to up 2% market. We expect Russia demand to be slightly higher in 2020.

No-Moat Automakers Versus Narrow-Moat Suppliers Economic moats are more prevalent among auto-parts suppliers than automakers, but given current market conditions, we believe that automakers' stock valuations are generally more compelling than those of suppliers. However, we see attractive values for some suppliers, too.

Aside from certain brands and protected national champions, automakers’ capital intensity and stiff competition often result in the destruction of economic value. Even so, a wide-moat stock can be expensive, like Ferrari, and no-moat stocks can be cheap. The latter is what we currently observe with Daimler DAI/DDAIF, Fiat Chrysler FCA/FCAU, Ford, GM, Nissan 7201/NSANY, Renault RNO, and Volkswagen VOW3/VOW/VWAGY/VWAPY.

Generally, suppliers producing consistent economic profits that translate into solid returns for investors enjoy the benefits of intangible asset and customer switching cost moat sources. We think the market has ignored the economic moats of some suppliers, making shares of narrow-moat Adient, BorgWarner, Continental CON, Delphi Technologies DLPH, and Tenneco TEN attractively valued.

Until recent market volatility brought down sector valuations, some suppliers had been valued as though economic cycles no longer exist. These stocks included Aptiv APTV, Autoliv ALV/ALIV SDB, BorgWarner, Continental, Faurecia EO, and Lear LEA. Aptiv, Autoliv, Faurecia, and Lear are now 3-star-rated, reasonably valued relative to our forecasts for their cash flows, while BorgWarner and Continental appear undervalued with 5-star and 4-star ratings, respectively.

Motors General Motors When GM announced its November 2018 restructuring plan, it issued guidance for about $6 billion in incremental free cash flow by the end of 2020 with $4.5 billion of that from net cost reductions and $1.5 billion from capital expenditure reductions (to about a $7 billion annual capital spending rate) as more global vehicle architectures roll out and some sedans are discontinued. The UAW strike's resolution put the $4.5 billion cost-reduction number at risk, but GM said in its third-quarter results that the cost saving is now projected to be between $4.0 billion and $4.5 billion, which is not a significant reduction to us.

There’s still lots to like about GM, in our view, even though we believe U.S. autos have peaked for this cycle. The 10 million-11 million U.S. industry sales rate for GM North America to break even is a data point we stress a lot because of the large change from Old GM, which had about a 16 million-unit break-even. This change means that GMNA now breaks even instead of losing billions if the U.S. industry light-vehicle sales rate falls back to the level seen during one of the worst-ever recessions. We believe the investments made now will allow GM to remain competitive throughout an economic cycle while still paying a generous--and safe, in our opinion--dividend currently yielding over 4%.

We have long believed that GM is more competitive with foreign automakers in the U.S. and that New GM is nothing like Old GM, which went bankrupt. One example is quality, where we think some Americans--especially on the West Coast who prefer Japanese brands--erroneously believe American vehicles are not competitive. We think that gap is a perception gap rather than an actual quality gap. One proof point comes from the 2019 J.D. Power Vehicle Dependability Study released in February 2019, which measures problems over three years for 2016 model-year vehicles. GM’s Chevrolet and Buick brands finished fourth and fifth, and GM beat Toyota in category wins. GM vehicles won five segment categories, the most of any manufacturer. In the 2020 study, GM won five awards while Toyota won six and three of GM’s four U.S. brands posted fewer problems per 100 vehicles than the industry average, with Buick finishing third behind Genesis and Lexus. We’ve seen data like this for a long time now, and it gives us confidence that GM can compete with the likes of Toyota and other foreign manufacturers.

We think GM may need to see a recession for its stock to rally so it can prove it really has changed. Guidance in the first year of a recession calls for about a 60%-70% adjusted EBIT decline, including GM Financial, but management expects adjusted EBIT to remain positive and for GMNA to remain profitable. The November 2018 restructuring is the type of move that GM would normally wait to make in a downturn, so this proactive move may reduce the special items in a recession. GM expects adjusted automotive free cash flow, which excludes the roughly $1 billion annual loss for Cruise, its autonomous vehicle subsidiary, to be neutral in Year 1, excluding a $5 billion working capital unwind, which comes from negative working capital and results from GM having to pay suppliers as sales fall in a downturn. We’d expect the working capital impact in Year 2 to be flat to slightly positive. If GM delivers on this guidance, it would not need to cut its dividend or use its credit lines, in our opinion. Guidance for adjusted automotive free cash flow in 2019 before the strike was $4.5 billion-$6.0 billion, which to us suggests that free cash flow should go several billion higher than that in future years as the roughly $6 billion of new free cash flow targeted by the end of 2020 ($4.0 billion-$4.5 billion in restructuring savings plus the $1.5 billion capital expenditure reduction) flows through.

If we model GM’s assumed recession sales downturn over two years of 25% but return our midcycle automotive adjusted EBIT margin to 6.4%, our fair value estimate falls 21% to about $38, not far from where the stock trades now, which we think makes it cheap but is also understandable because of fears of the cycle turning. This downturn modeling gives us confidence that GM’s stock would be a tremendous value in a recession following negative market sentiment (panic selling of the auto sector because of its capital intensity and cyclicality) that we expect would drive the stock well below $30.

We think once the market finally believes New GM is not like Old GM, the stock will not trade at price/earnings multiples of 5-6 times. However, GM may need to go through a recession to silence its skeptics. If so, the stock falling would be painful to existing shareholders, but we think the dividend would remain in place because of the cost-cutting and recession scenario discussed, GM’s ample liquidity, and the captive finance arm paying an annual dividend that GM has not enjoyed in recent years. GM Financial started paying a dividend back to the parent in 2018 of about $375 million and $400 million last year. 2020’s distribution is expected to double from 2019, and longer term we expect the payment will grow to equal the bank’s pretax income around $2.5 billion.

Cruise is another twist in GM’s valuation story. Following a $1.15 billion equity raise in May 2019 from previous Cruise investors SoftBank and Honda, along with new partner T. Rowe Price, that valued Cruise at $19 billion, GM’s valuation math looks interesting to us. At $19 billion, Cruise constitutes about 40% of GM’s market capitalization, which suggests the market is not valuing the core auto business much at all.

Before the strike, GM issued guidance for 2019 adjusted earnings per share of $6.50-$7.00; 2020 guidance is for $5.75-$6.25. If we assume adjusted EPS of $7 or higher is realistic for GM after the next downturn and the stock enjoys modest multiple expansion, we see significant upside for GM shareholders. For example, if we apply a forward P/E of only 8 times (compared with about 5.4 times currently) to a still conservative (in our view) $7.50 EPS estimate, the stock offers about 85% upside.

BMW BMW's narrow moat rating is derived from an intangible asset moat source, including brand and intellectual property in powertrains. Since 2002, the company's moat has supported an average of 8 percentage points of economic profit.

Our EUR 118 fair value estimate represents 93% upside potential versus the current market valuation. We think the market has priced BMW as though industry-disruptive technology spending will permanently leave margins at cycle lows, a view that we do not share, owing to the company’s narrow moat driven by premium brands across the entire product portfolio.

Our Stage I base case assumes 1% annualized industrial revenue growth versus 6% 10-year historical and average industrial EBIT margin of 6.4% versus the 10-year high, low, and median of 11.6% (2011), negative 0.5% (2009), and 9.0%, respectively. We assume a normalized sustainable midcycle of 7.5%. The company continues to expect a long-term 8%-10% industrial EBIT margin, with 6%-8% for 2019 excluding a charge for European Commission diesel equipment collusion among German automakers (4.5%-6.5% including the charge).

Assuming our estimated worst-case fine of EUR 9.9 billion if the EC finds that BMW colluded with other German automakers, our fair value estimate would drop to EUR 102 from EUR 118, still resulting in a 5-star rating. If our fair value estimate were EUR 102, the stock would be priced at a 40% discount to our fair value estimate.

Adient Spun off from Johnson Controls in October 2016, Adient is the number-one automotive seating supplier globally, with about 33% share of the $60 billion seating market. A series of execution problems continued in fiscal 2019, but there are sufficient signs of improvement to make us think that was the stabilization year management expected it to be in its turnaround plan lasting through at least fiscal 2023. Because of our long-term investing perspective, we recognize the stock's sell-off to $12.15 in March 2019 and recent levels in the $20s, from an all-time high of $86.42 in September 2017, as an excellent buying opportunity.

A drastically revamped management team led by president and CEO Doug Del Grosso, who joined the company in October 2018, has brought what we see as an improved focus on manufacturing processes, raising standards and accountability throughout the company, and a commitment to gradually unwind what were likely lowball pricing terms employed to build its backlog shortly before Adient’s spin-off.

Before a May 2019 refinancing, Adient carried $3.4 billion of debt with $1.2 billion maturing in 2021, but it now has no material debt maturing until fiscal 2024. We think this gives management enough time to not only fix Adient’s problems but also generate cash to reduce this debt obligation, which we think it needs to do. If more of the enterprise value shifts over time to equity from debt from less leverage, we expect the stock to go up multiples from where it trades in early 2020. The stock isn’t for everyone, because the turnaround is likely to take a long time. However, we don’t think the transformation has to finish for investors to make real money.

The path to Adient operating at an optimum level is a long one, but not an impossible one, in our view. When Del Grosso started at Adient, he told analysts that there was nothing wrong at the company that he had not seen before in his career. The problems are just on a bigger scale than one or two plants or one specific region. Improvement will take time, and for the investor who can stomach the volatility, we think Adient will eventually generate significant alpha from where it trades presently.

BorgWarner Narrow-moat BorgWarner trades at an attractive 46% discount to our fair value estimate. Based on valuation and business concentration relative to other Tier I suppliers where growth from hybrid and battery electric vehicle adoption has comparatively less impact, we think BorgWarner's shares represent an opportunity for investors looking to play auto-supplier stocks possessing technologies that enable vehicle makers to reach mandated clean air targets.

We think that some in the investment community misunderstand BorgWarner’s economic moat sources. Thus, the market incorrectly concludes that revenue will decline over the long term on shrinking demand for internal combustion engines, despite high growth potential in electrified powertrain technology.

We forecast annualized revenue growth that exceeds global vehicle demand growth by 2-4 percentage points. Growth stems from increased penetration in internal combustion engine vehicles as well as in vehicles with electrified powertrains. In our opinion, BorgWarner’s revenue growth is similar regardless of whether industry propulsion system demand remains internal combustion, switches to hybrid, or moves dramatically into battery electric.

Markets We expect global light-vehicle demand to be up 1% to down 2% in 2020. We expect the operating environment to remain favorable for industry profitability and returns, albeit moderating from 2019.

The 2020 global industry environment is clouded by the possibility of a no-deal Brexit trade agreement and escalation of international trade conflict. The United Kingdom has until the end of 2020 to reach a trade agreement with the European Union, even though it left the EU on Jan. 31. Given that the auto industry represents the largest amount of trade between the EU and the U.K., we think it is more likely than not that an agreement on automotive trade will be reached. Our worst-case no-deal Brexit scenario includes light-vehicle demand declines of 33% for the U.K. and 22% for the EU27.

We estimate world light-vehicle registrations were down 4.8% during 2019, coming in nearly at the midpoint of our revised forecast for down 4%-6% but below the flat to down 3% we forecast in March 2019. China and India were the largest misses in our 2019 forecast, while U.S. and Europe light-vehicle demand was slightly better than our forecast.

United States 2019 light-vehicle sales of 17.1 million came in slightly better than the 16.7 million-16.9 million we forecast in March 2019, likely due to unemployment remaining in good shape and leasing down but not collapsing. We still don't think the good times will last forever, and we think sales peaked for this cycle at about 17.5 million in 2016, but we see the U.S. industry in decent shape to start 2020. For 2020, we expect about a 3% decline from 2019 to 16.5 million-16.7 million.

Our 2020 outlook could be too conservative, given healthy U.S. employment levels, but the 2019 slowdown in light-truck penetration is a reason to think the good times are coming to an end soon. Light trucks’ share of U.S. new light-vehicle sales grew 290 basis points year over year in 2019 to 72.2%. This growth rate is less than 470 basis points in 2018 and 380 basis points in 2017. Car models are already seeing large declines (sales down 10.3% in 2019 versus light trucks up 2.8%), so at this point in the current business cycle, once light trucks’ growth engine stalls, we can’t see a reason for more growth.

Loan durations can’t rise forever, which is one reason we see U.S. auto sales peaking. Duration matters to affordability, and according to Experian data, the average new-vehicle loan term is 69.3 months as of the third quarter of 2019 compared with 68.5 months in the third quarter of 2018, up from the low 60-month range about a decade ago. Longer terms are how consumers keep their monthly payments low, but we do not see 15-year or 30-year auto loans as realistic, as the collateral is unlikely to last or be owned by the borrower for that long. The average U.S. new-vehicle monthly loan payment hit all-time highs in 2019 but held steady in the third quarter versus the second at $550.

We believe that leasing has already peaked for the cycle (2019 is likely the third straight year of annual declines in leasing as a percentage of new-vehicle sales), and used-vehicle prices are still elevated but should come down as more used supply enters the market. Off-lease in 2018 was nearly 4 million vehicles, and Cox Automotive expects off-lease vehicles peaked in 2019 at 4.1 million and will remain at peak levels in 2020. High-quality used vehicles had been in short supply because of new-vehicle sales plummeting in 2009 to 10.4 million, with off-lease volume bottoming in 2012 at only about 1.5 million. This dearth is over, and we expect some customers who have either been waiting for better used pricing and selection, or who bought or leased new in recent years when they normally buy used, will return to the used space.

The number of people unemployed continues to decline year over year, so the historical trend of a sales decline foreshadowing a rise in unemployment has yet to play out, but we think it’s just a matter of time. The number of unemployed people has declined year over year every month since June 2010, except for a 0.5% rise in September 2016. The rate of decline has slowed from high-double-digit levels in early and mid-2019 to declines of 3%-4% in late 2019. The labor market remains tight, which gives us confidence that sales are not going to collapse in 2020. The broader U-6 unemployment rate, which includes underemployed workers, has steadily improved since peaking in April 2010 at 17.1%. The rate started 2019 at 8.1% and finished at 6.7%. However, the U-6 rate during 2019 spent most of the year below where it bottomed out before the last recession at 7.9% in December 2006, according to data from the St. Louis Federal Reserve. These robust jobs numbers suggest a recession is not likely in 2020. However, we think there’s too much history in the sales and employment numbers to ignore the suggestion that the sales downturn foreshadows a downturn in the broader economy sooner rather than later and that sales are not likely to grow again in this cycle.

There are still many reasons to remain positive on U.S. demand, and we stress that current sales levels are still robust even though they are not growing. IHS released data in November 2016 that indicates about 23% of the fleet is at least 16 years old. Credit access is healthy, and we don’t see evidence of a subprime auto lending bubble, but delinquencies over 90 days are rising. Cheap gas gives people a reason to trade in, say, a 12-year-old sedan for a 2020 crossover or SUV. The average American vehicle is around a 2008 model year, and safety and technological features in those vehicles are, in our view, primitive relative to what is available in a 2020 model year.

Europe We estimate that the change in 2020 light-vehicle demand for the EU, including the U.K., will range from flat to down 2%, with unit registrations of 17.11 million-17.45 million. Despite the risk of a no-deal Brexit trade agreement, European labor markets remain healthy. Our worst-case no-deal Brexit scenario assumes a recession that results in a 33% cumulative decline for U.K. light-vehicle demand and a 22% cumulative decline for the EU27 member states.

European 2019 light-vehicle demand was relatively more healthy in the fourth quarter than we had expected on easier comparisons from the September 2018 implementation of the Worldwide Harmonized Light Vehicle Test Procedure, which created market distortions that resulted in aggressive pricing and a lack of availability of noncertified models in the prior-year period.

China We forecast a 4%-6% increase in 2020 Chinese light-vehicle demand. A burgeoning middle class and a relatively low passenger vehicle penetration rate, especially in Tier 2 cities located in the interior of the country, support our mid-single-digit long-term growth forecast.

In 2019, China’s light-vehicle demand dropped 8%, well below our forecast of a 1%-3% decrease. We attribute this weaker-than-forecast demand to limited government stimulus, negative wealth effects resulting from the prolonged trade conflict with the U.S., and reduced credit availability.

Sluggish demand has disproportionately affected local brands, while demand for premium vehicles has held up surprisingly well, posting year-over-year growth of 8%. We expect rising disposable income and replacement demand to drive demand for premium vehicles growing at above industry rates.

China’s progress in scrapping joint venture auto ownership laws requiring a Chinese owner means more joint ventures will be sold at prices favorable to international automakers, provided the foreign partner wants to spend the money.

The country’s new rules on capacity expansion are forcing potential entrants to acquire idled plants or outsource their production. We expect utilization rates to improve across the industry.

While the situation around the coronavirus outbreak remains fluid, our base-case view assumes that the near-term negative demand impact will be offset by rebounds in later quarters. Weaker demand will probably last into March as consumers worry about catching the virus and are less likely to go outdoors. But once the outbreak comes under control, heightened anxiety about using public transport and taxi services is likely to push people over the fence to purchase a vehicle, in our view.

Japan In our opinion, Japanese light-vehicle demand is on a long-term slightly downward trend. We forecast 5%-7% lower 2020 light-vehicle registrations.

Last year, light-vehicle registrations declined 1.6% because of an increase in consumption tax. In June 2016, a hike in consumption tax to 10% from 8% was delayed to October 2019 from April 2017. We think the change in tax policy caused demand to be pulled forward into 2017 from 2018. Similarly, light-vehicle demand modestly increased 3% in the first three quarters of 2019, ahead of the October tax hike. During the fourth quarter last year, sales dropped 16.1%.

India We expect trough volume in 2020, estimating flat to up 2% light-vehicle registrations to roughly 3.6 million units. Long term, we view demonetization and tax reform as positives for India light-vehicle demand, in conjunction with a growing middle class, supporting mid- to high-single-digit average annual growth rates.

Economic conditions rapidly deteriorated in 2019, much quicker than we had anticipated. In 2019, light-vehicle registrations declined 12%, slightly better than our revised forecast for down 13%-15% but much worse than our original forecast for a 4%-6% increase.

Until March 2019, trailing 12-month light-vehicle registrations were up 5%, in line with our original forecast. But tightened credit policies, changes in insurance regulations that led to higher premiums, and higher fuel costs severely damped 2019 light-vehicle demand. In the fourth quarter, though, light-truck demand showed signs of recovery, increasing 8% versus the fourth quarter of 2018.

Brazil We forecast an 8%-10% increase in 2020 Brazilian light-vehicle registrations to roughly 2.9 million.

In 2019, total light-vehicle registrations for the year increased 7.6% to 2.66 million, at the upper end of our revised forecast for a 6%-8% increase, down from our original forecast for a 10%-12% rise. Labor reforms have supported lower unemployment rates and positive quarterly GDP growth since 2017, but unpopular pension reform moderately damped 2019 light-vehicle demand growth relative to the 2018 13.7% increase.

This South American country has always been a volatile market. Despite hosting the 2016 summer Olympics, political unrest resulted in a 20% plunge in 2016 demand, after a 25% nosedive in 2015.

Russia We estimate flattish 2020 Russian light-vehicle registrations. International sanctions, government austerity, and moderating oil prices are headwinds to continued recovery in the Russian market.

The Russian national economy depends heavily on the oil industry. With the price of a barrel of Brent North Sea oil declining 47% and 17% in 2015 and 2016, respectively, light-vehicle demand dropped 27% and 20% during the corresponding time frames. Despite international sanctions, with a 29% average increase in the price of Brent North Sea oil during 2018, Russian light-vehicle demand grew 12.8% last year.

The price of a barrel of oil has moderated, but considering a projected government budget surplus, accommodative monetary policy, and consumer recovery from the January 2019 VAT tax hike to 20% from 18%, we expect moderate 2020 light-vehicle demand improvement.