The U.S. Could Be on the Verge of an Auto Price War

The U.S. auto industry endured a second-straight month of weak sales activity in February. Among the top eight automakers, Nissan and Chrysler posted surprising double-digit-sales gains in the U.S. last month, propelled by big discounts.

However, all of the others, including Ford (NYSE: F  ) and General Motors (NYSE: GM  ) , posted sales declines. As a result, total industry sales came up somewhat short of most analysts' expectations.

It's hard to blame the automakers for the weak sales trends. The U.S. has been hit with one big winter storm after another in 2014, and the bad weather has been keeping potential car buyers away from dealer lots. Nevertheless, if auto sales don't accelerate in a hurry, a price war could be brewing for the spring.

Inventory rising
Thus far, automakers have not made significant production cuts despite lower than expected auto sales in the U.S. this year. As a result, auto inventories have risen noticeably.

For example, Ford ended February with 91 days of supply in inventory, compared to 71 days of supply at the end of February in 2013. (Sixty days of supply is considered typical in the auto industry.) The rise in Ford's car inventory was particularly stark, jumping 40% year over year from 176,000 to 247,000. Truck and SUV inventories increased at a more moderate pace.

Auto inventories are rising at Ford.

GM posted somewhat better sales results than Ford -- total sales declined 1%, compared to a 6% drop at Ford -- but it still ended February with 87 days of supply in inventory. Chrysler had 85 days of inventory, putting it in the same ballpark as its Detroit brethren. Overall, U.S. auto inventories are up 7.5% year over year, even though demand seems to be leveling off.

Discount risk rises
Coming into 2014, there was a clear risk of increased price competition in the auto industry. After four years of strong sales growth helped U.S. new-vehicle sales rebound 50% from the depths of the Great Recession in 2009, most industry experts expected much slower growth in 2014.

While a rising tide lifts all boats, in a slower-growth environment, automakers are likely to get more aggressive on pricing to maintain or gain share. The sluggish sales trends seen so far in 2014 and rising auto inventories further increase the risk of an auto price war.

Even if the weak sales trends can be attributed wholly to weather issues, the fact remains that automakers need to bring down inventory levels soon. Otherwise, they run the risk of being unprepared if any demand shock were to occur.

GM reported a small increase in its incentive spending for February, and claims that other manufacturers increased incentives even further.

GM increased incentives last month, but sales still declined 1% year over year.

Given that this elevated incentive spending was not effective, automakers are likely to ratchet up the discounts yet again in March. GM and Ford have already extended many of their February incentive programs through the end of March, and both companies appear to be boosting discounts even further on some models.

The big unknown
The ongoing crisis between Russia and Ukraine represents a giant question mark for the auto industry -- and the U.S. economy as a whole. While the situation seemed relatively stable on Tuesday after Russian President Vladimir Putin ended a provocative military exercise, there is still a significant risk that the conflict could escalate.

Even without an all-out war, if the Russian military presence in the Crimea increases and the U.S. and other Western countries retaliate in some way, consumers may start feeling jittery. This could be just as effective as bad weather in dragging down U.S. auto sales.

With auto inventories already near a five-year high, that could force the automakers to either push incentives higher or to schedule significant production downtime in Q2. Either way, there would be a significant hit to automaker profit margins this year.

Foolish conclusion
Automakers were dealt a bad hand in recent months, as severe weather kept potential car buyers home. This has resulted in a significant increase in auto inventories in the first two months of 2014.

Ford, GM, and their brethren need to have a good March in order to reverse this inventory buildup. They are already ramping up incentive spending to help bolster March sales. However, if sales fall short of expectations yet again -- for instance, if consumers pull back on major spending due to fear about the ongoing crisis in Ukraine -- a full-blown auto price war could materialize this spring.

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