Automotive Inventories and Incentives Rise -- Time to Panic?

Many investors fear jumping into the automotive industry for multiple reasons. For one, the industry is littered with companies like General Motors (NYSE: GM  ) , Ford (NYSE: F  ) and Chrysler, which have been terribly managed in the past -- though that is changing, and quickly. Before and during the recession, automakers had to weather sky-high inventories and offer huge incentives, and we know how badly that ended. With those two factors rising again, are we reaching a similar situation?

I don't think so, and to try and help the world invest better, I'll explain one variable to help you gauge the health of the industry, and give you a sense of where it's headed.

Average transaction prices
One simple variable to always follow when investing in the automotive industry is average transaction prices, or ATP. When demand exceeds supply, average vehicle transaction prices rise, and it's a healthier automotive industry for both the auto companies and their investors. Higher prices typically equal higher profits, as long as incentives aren't rising out of control.

After our nation exited the most recent recession, ATPs have consistently been on the rise, as demand to replace older vehicles grew. However, in November, a red flag was raised for some analysts when ATPs declined, for the first year-over-year drop since December 2010. ATPs dropped $198, to $30,634, reflecting an increase in incentives used to sell vehicles as competition increased.

One reason for the increased incentives is surely the holiday season. The automotive industry is very seasonal, and we typically see a bump in incentives during this time period. In addition to that, inventories are also higher, as some manufacturers build extra supply because they schedule plant production downtime around this time of the year when certain models are switched from 2013 to 2014 production.


Graph by author. Inventory information from Automotive News DataCenter

Ford's rise in inventory isn't unusual, and the rest of the industry is experiencing similar trends. That's driving higher incentives, as well spurring dealerships to push older 2013 inventory off their lots. There's also more that goes into incentives, which we'll get to in a second; but first, take a look at overall incentives.


Table by author. Information from TrueCar.com 

There are a couple of things to take away from this table. First, Detroit's Big Three automakers have significantly higher transaction prices because they all sell drastically more full-size pickup trucks than import brands. Those sales bring in significantly higher ATPs and profits.

Secondly, you should notice that General Motors' year-over-year ATP spiked, and is well ahead of all competitors. This is largely because General Motors has unleashed brand-new redesigns of two of its highest volume, and highest ATP, vehicles: the Silverado and Sierra.

With all-new or redesigned models, fewer incentives are needed to sell the vehicles to consumers. On the other end of the spectrum, Ford's F-Series is in its last year before its next-generation design hits the showrooms next year. That means that, to compete with General Motors' redesigned full-size pickups, it must dish out hefty incentives, which contributed to its 23.4% increase in year-over-year incentives.


Table by author. Information from TrueCar.com

What you learned
You now better understand how to gauge the health of the automotive industry through average transaction prices, and why certain manufacturers have higher ATPs and incentives. You also better understand why inventories and incentives rise toward the end of the year. With all that, let's take a look at where the industry is going from here.

Going forward
Right now, Ford and General Motors are much better at matching supply to demand, sending margins higher than we've seen in years. Both have also focused on improving operations and consolidating global vehicle platforms, which enable stronger bottom-line profits. Management of both is a night-and-day improvement to the Detroit automakers we knew a decade ago.

The other end of the equation is having consistently strong demand for new vehicles, and that looks to hold true going forward. The economy is steadily creating new jobs and household wealth. Energy costs are dropping, and credit is still easily available and affordable. In addition to those factors, the age of vehicles on the road is at a record high of 11.4 years, meaning pent-up demand still exists.

Moreover, people tend to forget about scrap rates. Vehicles don't last forever, and research shows that consumers scrap their cars entirely at a much higher rate when vehicles reach 13 years of age. That means that, as the average age of a vehicle is nearing 13 years of age, we'll see additional demand for new and used vehicles as scrap rates rise.

While November saw a recently rare decline in average transaction prices, I believe it isn't a red flag -- merely a byproduct of the industry's seasonality. Demand looks strong going forward and, with better management, I'm very bullish on the futures of both Ford and General Motors.

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