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If You Own Ford, Time to Take a Look at Honda, Too?

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As bad as Toyota (NYSE: TM  ) has had it in recent months, rival Honda (NYSE: HMC  ) may have had it even worse. For decades, Toyota's fellow longtime Consumer Reports darling could do no wrong in the U.S. market -- but in recent years, a series of product missteps have undermined the company's reputation with consumers. And as with Toyota, production disruptions in the wake of the March tsunami have taken another big bite out of Honda's already-depressed sales.

Honda's stock has also been hit hard since the tsunami, dropping from the mid-$40s down to $29.59 as of Thursday's close. Percentage-wise, that's a larger drop than Toyota and Nissan (OTC: NSANY) shareholders have seen. In fact, it has been large enough to drop Honda's price-to-earnings ratio down around seven, not far from Ford's (NYSE: F  ) .

Ford is arguably a fine value at current prices and has attracted a lot of investor attention. So what about Honda?

It starts with the product
Once the darling of critics and consumers alike with its small lineup of meticulously engineered, fuel efficient vehicles, Honda in recent years has seemed to lose its way on the product front. That was especially apparent with the debut of the new Civic compact earlier this year. Honda's Civic was for many years the small-car gold standard, a dead-reliable and fun-to-drive model that won acclaim (and sales) from commuters and car enthusiasts alike.

But the latest version, introduced a few months ago, has landed with a thud. Consumer Reports had long placed the Civic at or near the top of its charts -- but this new one didn't even earn a "recommended" designation. "The new Civic feels insubstantial with a cheap interior," the magazine said, before launching into more serious concerns about the car's ride and handling. The upshot, according to the review, was that the Civic wasn't up to the "high bar set in this class" by products from Ford, General Motors (NYSE: GM  ) , and Hyundai (OTC: HYMTF).

If it were just this one car, we could write it off as a stumble. But Honda's product mojo has been missing for a while now. The bread-and-butter Accord is still recommended by Consumer Reports, but it's overweight and noisy and has fallen behind more impressive offerings from Nissan and Hyundai -- and the all-new Ford and Chevy entries due next year may blow right past it as well. Honda was once a hybrid innovator, but its latest models have been thoroughly eclipsed by stronger offerings from Toyota and Ford, among others.

As goes the product, so goes the company
Product is everything to an automaker, and I firmly believe that it's where analysis of any auto stock needs to start. Put simply, vehicles that don't compare well with segment leaders have to be discounted to sell well. Discounts hurt margins, reducing profits -- and reducing the capital that can be reinvested to improve the next generation of products. Over time, a company whose product lags can become reliant on incentives, stuck in a perpetual second-tier, low-profit status -- just as the Detroit companies were a few years ago.

Ford had to mortgage everything it had back in 2006 to make the investments necessary to reverse that cycle, and GM needed a bankruptcy to be able to follow suit. Now, after painful restructuring, Ford has a consolidated global lineup of class-leading products, just like Honda used to have. Meanwhile, Honda has gone in the other direction, with a mishmash of regional models (the Accord and Civic sold in Europe are not the same vehicles as their U.S.-market namesakes) and vastly different brand strategies in different markets, an arrangement that increases costs and complexity.

And this company has other problems
Honda's margins, like Toyota's, have also suffered from the appreciation of the yen versus other major global currencies, which has added several thousand dollars of cost to cars that are made in Japan and exported to the U.S. or Europe. Honda President Takanobu Ito said on Wednesday that the company is planning to cut exports from Japan in half and increase production elsewhere, but that transition may take a decade to unfold (and may meet with stiff resistance in Japan).

Honda's production is nearly back up to full speed -- U.S. sales in September were up 37% over August, though the fact that they were still down 8% over last year's numbers may suggest lingering weakness. Supplies of the new Civic have continued to be constrained by earthquake-related parts shortages, but the 16.1% drop in Accord sales for the year to date has to be worrisome.

The Foolish takeaway
I would recommend the stock in a heartbeat if I saw serious evidence that Honda were getting its product act together -- rationalizing product lines and making major investments to produce the kind of innovative, truly class-leading cars and trucks that used to be its hallmark. It'd be a steal at current prices, especially if you think the global economy will bounce back.

But I'm not seeing that. In fact, what we're seeing is more the opposite. Hondas still aren't bad cars, and the company isn't in dire straits. But every year, Honda looks a little less like the powerhouse of old and more like a second-tier player, and that's not a trend I'd want to add to my portfolio.

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Fool contributor John Rosevear owns shares of Ford and General Motors. You can follow his auto-related musings on Twitter, where he goes by @jrosevear. The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of Ford and General Motors. 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.


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