The U.S. economy facing rising interest rates for the first time in the better part of a decade should put the brakes on the roaring U.S. auto industry, and led to a downgrade of the sector by Patrick Archambault, Goldman, Sachs & Co. analyst, Tuesday.
The earnings growth in the sector has played out better than expected over the past three to four years as the industry recovered from a thorough restructuring that not only streamlined costs but introduced price discipline as well, Mr. Archambault said.
“We are not arguing for a reversal of these operating trends, but rather that the sector’s growth outlook for the balance of this cycle appears to be now largely discounted in the shares just as we enter into a phase of tightening long rates, which has typically been negative for auto valuations,” he said in a note to clients.
The auto sector is up 46% year to date, and 85% since its June 2012 trough, and is pricing in “quite a bit of good news” over the past quarter with U.S. auto sales hitting 16 million units for the first time since 2007 on a seasonally adjusted basis, improving comps in Europe, and a firming U.S. macro backdrop, he said.
But historical data suggests that rising interest rate environments are difficult for auto stocks, which have underperformed the S&P 500 by an average of 25% over the last three major tightening periods, Mr. Archimbault said.
“What is notable is that this has occurred even in the face of improving auto demand and consumer confidence, which increased an average of 4% and 30% during these episodes,” Mr. Archambault said. “Most of the underperformance has been primarily driven by a contraction in multiples as during these periods as auto sales and [earnings-per-share] estimates have continued to grind higher.”
As a result, he moved his coverage view for the sector to neutral. He said he believed a more balanced view of the sector was justified, and investors should put an emphasis on stock picking over a broad sector call.
“The best opportunities in our view remain product cycle stories like Ford and [General Motors], which can see share and pricing gains that are incremental to a macro driven volume recovery” he said. “We also like late-cycle end- market exposure like tires and commercial vehicles, which are still earlier in their recoveries than light vehicles.”
He said he also liked the rate-driven balance sheet improvement opportunity at companies with pension exposure.
- GM is a top pick because there are several near-term catalysts for the stock, Mr. Archambault said. He said that included an anticipated positive impact on margins in the second half of the year driven by North American pricing, volume and mix. He also likes its prospects for a common dividend, possibly by year end, and said he sees the stock significantly leveraged to rising rates. He has a buy rating on the stock and a US$45 a share 12-month price target.
- Ford has had an impressive run this year with its shares up 33% year-to-date versus GM, which is up 27%. But he said he still sees the automaker as a buy with a housing-fueled recovery driving pickup sales, a mitigation of losses in Europe with the most-aggressive turnaround plan of all manufacturers, and a product-driven recovery in Brazil and Asia. He has a US$20 12-month price target on its shares.
- Mr. Archambault also has a buy on Meritor (US$9, 6-month target), Goodyear (US$20, 6-month target) and Lear (US$78, 6-month target).