Autos on the edge

auto sector

Unwilling to cede its position as the most volatile sector in the credit markets, the auto manufacturers are once again dominating analysts’ conversations. Pressure is mounting on the Big Three automotive makers, who are being threatened by overcapacity issues, the loss of market share to foreign car manufacturers and the burden of unwieldy pension obligations. Investors have taken note, and are keeping a close account of investment opportunities while trying to avoid the next pitfall, while the rating agencies seem to be circling with an ever-watchful eye.

While there are numerous challenges facing the US automotive industry, analysts have shown increased concern over the high level of inventory being held by the Big Three. Banc of America Securities reports that inventory levels have reached historic highs in recent months. During July, the bank estimated an industry-wide inventory of 3.6 million units, which marks an increase of 500,000 units over the same month last year.

The saturation of dealer lots with 2004 models is the result of several underlying problems encroaching on the performance of the automotive industry. One problem that domestic manufacturers are dealing with is the introduction of new car models by foreign competitors. According to data from Ward’s Automotive, sales of domestic cars in July slipped to 490,087 units, marking a decrease from 494,083 during the same month last year. In contrast, during the same time periods, the number of foreign cars sold increased from 185,997 to 191,949.

Scott Sprinzen, managing director of corporate and government ratings at Standard & Poor’s, says that decreased market share for US automotive manufacturers, especially for Ford, is a concern. “Inventory is a big problem there and that’s going to necessitate sharply reduced production in the second half, which is going to account for much weaker earnings in the second half compared with the first,” he says.

In a recent conference call, Ford confirmed Sprinzen’s outlook. George Pippas, US sales analysis manager at Ford, noted that fourth-quarter production estimates for North America are at 830,000, a drop of 70,000 on the same period in 2003. Sales were also down 13% during August.

Sprinzen expresses similar concerns about General Motors. Addressing the increase in inventory and deterioration in vehicle mix, he says, “There are a number of disturbing signs in the North American business.” General Motors announced August sales for new cars and trucks stood at 406,623 units, down 7% on last year. In addition, GM North America set its initial fourth-quarter production forecast at 1.29 million vehicles (492,000 cars and 798,000 trucks), down 6.8% on last year’s fourth-quarter production.

In the mid-August conference call, Standard & Poor’s affirmed its negative outlook on General Motors, anticipating a weak performance during the second half of the year. According to Sprinzen, the performance of the stock market has placed significant pressure on the pension funding, which he anticipates will increase by the end of the year. He also warned that General Motors could also be downgraded in the future if the agency’s concerns about future performance continue to escalate. Sprinzen also anticipates that on a full-year basis, market share will not reach the levels of 2003 for either Ford or GM.

Some analysts note that the integration of fuel-efficient technology into new vehicles by foreign manufacturers is also helping to gain market share from the Big Three. With oil prices reaching record highs, especially during the summer when the market nearly hit the $50-per-barrel mark, analysts have noted that consumer demand for vehicles with hybrid technology, such as the Toyota Prius or Honda Civic, is steadily growing. The technology combines gas and electricity to help power the vehicle more efficiently while reducing emissions and fuel consumption.

Some investors call into question the ability of the domestic manufacturers to regain market share as a result of an inferior product. “Foreign competition is taking away market share by providing higher-quality products,” says Cindy Cole, portfolio manager at National City Investments.

While higher-quality products may shift consumer demand away from domestic cars, manufacturers are hoping that greater incentives will bring them back. Yet, many are unconvinced that greater incentives than those already being offered will help offset the overall weak demand for vehicles.

Cole suggests that demand for automobiles has slowed due to post-9/11 dealer incentives. “Following 9/11, many people bought cars due to 0% financing incentives being offered,” she says, adding that cars bought during that time are only a few years old now. Cole questions whether owners of such vehicles are ready for a new car.

The latest data from Banc of America Securities suggests that they are not. In a recent report, Ronald Tadross, senior auto and auto parts analyst at Banc of America Securities, highlights a weak consumer-spending environment. Moreover, the estimate for the seasonally adjusted annual rate—which represents the number of automobiles sold per year—has been readjusted to reflect 16.8 million units, down from the earlier prediction of 17.7 million units for the year.

Yet chief economist at Ford Motor Company, Helen Hughes-Cromwick, notes that some of the latest data on vehicle sales has been affected by seasonal factors, such as weak consumer spending. She also notes that the current annual number of units sold per year is up from approximately 15 million units just several years ago.

Rising pressure

Inventory levels are merely one bump in the road for domestic auto manufacturers. Increasing production costs and operating costs are adding additional pressure to the Big Three. One factor that has also been garnering much attention from analysts is the price of steel. Carl de Jung, director of high-grade credit research at Deutsche Bank, says that the long-term steel contracts with automotive manufacturers are set to expire in the upcoming months. Steelmakers will most likely pass the increase in the price of steel production on to automotive manufacturers. According to Bloomberg, a report issued by Nikkei English News anticipated that Nippon Steel—the world’s third-largest steel producer—and other steelmakers planned incremental increases of 10% for each meeting with automakers in October and April.

Pension liabilities are also adding stress to automotive manufacturers. According to Standard & Poor’s, while Ford’s unfunded liability has reached $11.7 billion, down from $15.2 billion at year-end 2002, it still remains relatively large. Retiree liabilities at General Motors paint an even more dismal picture, as rising health-care costs are bearing down on manufacturers. In Standard & Poor’s ratings assignment, Sprinzen notes that General Motors’ unfunded retiree medical benefits remain massive at approximately $51 billion. De Jung at Deutsche Bank agrees, “Health-care costs remain inflationary and problematic and the problem of unfunded pensions will continue to resurface.”

The sentiment of credit investors about the automotive industry can be seen in the secondary market. There have been several different trends in spread performance for US auto manufacturers. In general, yield margins of short-term paper for the Big Three have shown a tightening trend year-to-date.

In light of all the obstacles that automotive manufacturers are facing, some wonder why spreads have been able to perform as well as they have in this sector. De Jung explains, “Shorter-term maturity papers have done better because of more comfort around liquidity.”

One example of the short-term financial flexibility and liquidity that are contributing to short-term spread performance is General Motors. In addition to having unrestricted access to a $5.6 billion bank credit facility expiring in 2008, $800 million in committed credit facilities with various maturities, and uncommitted lines of credit of $1.7 billion, General Motors has a large liquidity position of $25 billion as of June, according to Standard & Poor’s.

Similarly, Ford Motor Company had $26.8 billion in cash, marketable securities and short-term Veba (voluntary employee benefits association) funds as of June. Standard & Poor’s also notes that Ford Credit has entered into agreements with several bank-sponsored issuers of asset-backed commercial paper. These issuers have agreed to purchase up to $8.3 billion of Ford Credit’s receivables.

Given the liquid positions, short-term paper for the manufacturers has performed well year-to-date. Yet, de Jung says that the heart of credit risk is in the long end of the auto curve. Specifically, he points to the spread performance of General Motors 8.375% bond due 2033 since January. At the beginning of the year, spreads on the 2033 notes were trading in the range of 181bp. By the end of August, the notes had widened out to 289bp.

Down the road

Despite the numerous challenges that the automotive industry is facing, many agree that there are several things that the Big Three can do to mitigate losses from these factors. Fitch Ratings notes that the ability to quickly turn over products to meet ever-changing consumer needs will no longer be a competitive advantage, but a necessity. In a report, the rating agency says that the once-acceptable standard of a six- to eight-year product development cycle is no longer sufficient. To remain competitive, manufacturers will likely have to reduce their product cycles to fewer than six years. The quick turnaround in the product cycle would offset the potential slump in demand between models. According to Fitch, this practice has become commonplace in Japan, allowing manufacturers to quickly gain market share. The report also finds that in the future, it will be likely that automakers will begin working on refreshing a product as soon as they launch the original version.

De Jung agrees that fine-tuning the product cycle will help to offset potential market and earnings losses in the future. He says that a revival at Nissan was made possible by a dynamic new product design. For domestic manufacturers, de Jung suggests that the success of Ford’s F150 and Chrysler’s 300c could replicate this effect. Yet, he warns that the probability of one of the Big Three introducing a string of very successful products is low in what is a highly competitive industry. Most likely, there will be a mix of successful vehicle lines and less successful vehicles.

The integration of technology into vehicles will also help drive demand, according to many analysts. While the technology integrated into vehicles in recent years has included such things as entertainment centers, many highlight the need for manufacturers to include hybrid technology.

Joe Robison at National City says that while Ford is placing a lot of emphasis on the integration of hybrid technology with the introduction of its Escape model, General Motors seems to be less active in this area of development. Furthermore, GM’s new product lines are lower-end models, which many agree will not have the profit margin of higher-end models.

While the road ahead may be difficult for US automotive manufacturers and credit investors alike, de Jung says that investors will remain in the market. “It’s too risky to ignore the automobile industry,” he says.