There were numerous interesting takeaways from the Wolfe Research Auto Conference in Detroit, including revealing insights into recent shifts amongst U.S. New Vehicle Buyers (there may be less risk to industry mix than we perceived), the trajectory of battery costs, insights into Powertrain plans being made by Auto OEMs, and revelations on the Ride-Share business model. All of these have long term implications.
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There were 3 major takeaways from GM’s CMD on Friday (1/11/19): 1) Prospective tailwinds appear to significantly exceed potential headwinds for GM’s core Auto business; 2) GM’s earnings runway is much longer than the Street appreciates (extends into 2020 and beyond), and; 3) GM reinforced our view that they are on track to achieve impressive value creating milestones at Cruise. Investor confidence is the primary driver of multiple expansion/contraction for Auto Stocks. Confidence in GM’s prospects should be on the rise. And the opportunity for upside is compelling. We reiterate our Buy, $50 target.
The Market is bracing for challenges as we transition to 2019, including lower Auto Production (particularly in China and Europe during 1H19), higher Rates (which raise concerns about Mix, Pricing), the strong U.S. Dollar, Regulatory Content, unpredictable Government Policy/Tariffs, the burden of increased Spending on Technology with uncertain returns, and in some cases discontinued passenger car products.
Most major U. S. OEMs and Suppliers will provide 2019 guidance in mid- to late-January… at our Detroit Auto Show Conference (Jan 15-16), or when they deliver Q4 earnings late January/early February. Management teams are pulling these forecasts together now. And they are doing so amid an unusually large number of market uncertainties (i.e. China, Europe, and NA production; company specific concerns for Ford (China, UK), JLR (China, UK), GM (discontinuing models), and local Chinese OEMs (declining at a double-digit rate in their domestic market). Based on our discussions with Industry Management teams we suspect that most will incorporate an extra dose of conservatism into their 2019 Guides. We are fine-tuning our estimates for Lear, Visteon, and Autoliv as we intend to take the same tack (e.g. today, we are fine-tuning our 2019 net new business backlog estimates, initially provided in early 2018, to reflect updated market and FX assumptions). See pages 3-6 for more details.
The current auto sales run rate in China, if sustained, would imply a 10% sales/production decline in 2019. Europe won’t be easy either, as production headwinds spill into 1H19. The U.S. has been relatively strong, but we remain concerned about affordability headwinds. Given these uncertainties, we question why OEM/Supplier margin expectations are up from 2nd half 2018 levels.
Late Sunday night (12/02/18), President Trump tweeted that China had agreed to reduce the tariff on vehicles produced in the U.S. and exported to China (China had increased this tariff from 15% to 40% in August). In addition, the U.S. will refrain from ratcheting up tariffs (would have gone from 10% to 25%) on $10.4 bn of Chinese made Auto Parts that are imported to the U.S. Although we have no detail as of yet, and these actions are contingent on the U.S. and China making progress towards a permanent trade agreement over the next 90 days, this development could have meaningful positive implications for U.S. Automakers and Suppliers:
Our Outperform recommendation on GM was based on 2 major pillars: 1) We believed that the potential upside from GM’s AV business was too large to ignore, and; 2) We believed that investors underestimated the magnitude of positive earnings/cash flow drivers in the pipeline. GM’s restructuring plans, announced early Monday, underscored our view. And frankly, we do not believe that the magnitude is yet fully appreciated. Clients are still asking us what the “real net cost reduction number” might be. Folks, $6 bn is the “real net number”. Over the next 2-years GM believes that its fixed costs should decline by $4.5 bn, and capex should decline by $1.5 bn. There is no offsetting negative from higher EV or AV spending (within GM’s reduced cost structure, spending will be increasingly redirected towards EVs).
Once a quarter, we comb through corporate filings and summarize the most noteworthy datapoints. At a high level, developments during the quarter reinforced our view that investors should be Underweight Autos and Auto Parts, Underweight Dealers, and Overweight a relatively small selection of companies that fall into the Auto 2.0 category. In our view the U.S. Auto Cycle is in its 8th or 9th inning, with looming pressures on vehicle affordability. China is experiencing its first real Auto Industry downturn, and we are not convinced that the Central Government will step in to specifically prop up Autos. Europe also faces a number of challenges: These include potential trade risks (7% of Europe produced vehicles are exported to the U.S.), political risks (Brexit), and regulatory risks (vehicles more expensive to produce, at the same time that pricing has become more challenged).
We were impressed (and a bit relieved) to see GM’s Q3, reported early Wednesday Morning (10/31/18). And the Street clearly agreed, as the stock rose 9% through the day. The quarter itself may have looked a bit better than it really was: 3Q18 EPS of $1.87 included a $0.33 unexpected benefit from an unusually low tax rate and a mark to market on PSA Warrants. Inventory building in China also helped. And we acknowledge that on an apples-to-apples basis free cash flow guidance was actually lowered (ex the dividend from GMF, 2018 FCF is now $3.6 bn vs. $4.0 bn previously).
GM reported 3Q18 EPS of $1. 87 before the open this morning (10/31/18); well above WRe of $1.09 and Consensus of $1.25. 3Q18 EBIT came in $3.2 bn vs. WRe $2.2 bn (likely including a $0.3 bn gain in Corporate). And management effectively raised guidance, indicating that they may hit the top of their previous $5.80-$6.20 guidance range for 2018, due in part to a lower tax rate, but also due to better performance. While this implies a bit of a pullback in Q4 (to EPS of $1.09, slightly below WRe of $1.21 and Consensus of $1.38), we nonetheless expect a positive reaction to this print. Fundamentally, GM’s earnings are derived from 2 main sources: North America (trucks) and China. North America had a very strong Q3 (EBIT $2.8 bn / 10.2% margin vs. WRe $2.5 bn / 9.0% margin), primarily due to lower than expected costs (price and volume were better, but this was offset by lower mix due to the Truck changeover). But even more noteworthy was the strong performance from China, where equity income came in at $0.5 bn, well above WRe of $0.3 bn and in-line with 3Q17 of $0.5 bn. GM’s also indicated that they expect to sustain $2 bn of equity income from China for the full year (similar to 2017 levels) despite more challenging conditions in this market. Volume is clearly lower in China. But so far GM appears to be offsetting this weakness with very strong mix (Baojun and Wuling are down, but Cadillac is up). We believe that GM could re-rate significantly higher if they are able to convince the Street that China earnings and cash flow are sustainable (China accounts for almost $2 bn of free cash flow for GM).
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