No one said investing was easy. Stocks in the auto sector look a great value, and their prospects will surely improve over time. But the industry continues to be plagued by supply chain issues, component shortages, and the ongoing struggle to ramp up production. It's a classic case of near-term risk and long-term opportunity.
Here's why the auto sector faces red and green flags simultaneously and the best way to invest in it.
Auto industry challenges are a red flag waving
It's an incredibly frustrating time for the auto industry. It's no secret that traditional vehicle producers are under time pressure to maximize sales and profits from internal combustion engine (ICE) models while the transition to electric vehicles (EV) occurs. However, a series of external issues (semiconductor shortages, China lockdowns, component shortages due to the ongoing conflict in Ukraine, etc.) have caused downgrades to light vehicle production (LVP) estimates.
Image source: Getty Images.
The best way to monitor LVP is by looking at how a leading industry forecaster, such as S&P Global's IHS Markit, is adjusting its full-year forecast as the year progresses. IHS Markit started this year forecasting a global LVP of 82.3 million units, with Greater China producing 24.5 million units, Europe 18.5 million units, and North America 15.2 million units.
As you can see, those estimates were broadly lowered by March. The latest forecast (April) shows significant reductions globally, driven by Europe and Greater China -- lockdowns and component shortages exacerbated by the conflict in Ukraine.
| Region |
Full-Year Production Forecast in April (units) |
Full-Year Production Forecast in March (units) |
Change (units) |
|---|---|---|---|
|
Europe |
16,492,975 |
16,991,170 |
(498,195) |
|
Greater China |
24,625,455 |
25021682 |
(396,227) |
|
North America |
14,745,564 |
14736319 |
9,245 |
|
Rest of the world |
24,760,939 |
24,806,204 |
(45,265) |
|
Global LVP |
80,624,933 |
81,555,375 |
(930,442) |
Data source: IHS Markit.
Unfortunately, near-term momentum is not on the side of the auto industry, and that's creating near-term risk for the industry. Take Ford (F -0.41%) for example. Management plans for 50% of its global sales to come from EVs by 2030. That's a worthy ambition, and it's indicative of the industry shift to EVs from ICEs. However, every delay in ICE production is lowering the value of the ICE brands because Ford and others need to maximize value in their traditional ICE units as the momentum toward EVs builds.
Demand is a green flag waving
It would be remiss not to point out that there's strong evidence to suggest an improvement could be on its way. First, while automakers are still struggling to obtain semiconductors, and it takes time for new auto chip manufacturing capacity to come online, the fact is the major auto chipmakers are massively ramping spending. It will take time, but new capacity will come in time.
Second, anecdotal evidence suggests strong demand for cars. For example, a major U.S. automotive retailer, AutoNation (AN -1.47%), reported a whopping 18.6% year-over-year decline in new vehicle sales in the first quarter due to a lack of availability. Still, the average revenue per new vehicle rose by 15.7% to around $50,000. Moreover, the average revenue per used vehicle rose 31% to nearly $30,000. Demand continues to outstrip supply.
In addition, Ford maintained its full-year earnings before interest and taxation guidance of $11.5 billion to $12.5 billion on the back of a "strong demand and pricing environment." This comes after Ford's first-quarter wholesale unit sales declined 9% year over year in the first quarter.
Whichever way you cut it, the demand environment remains strong. The question marks right now are around when manufacturers get the components to ramp production to meet it. Granted, part of the reason for strong pricing is that the supply of new vehicles is limited. Still, it's better for Ford et al. to sell their ICE models into a pricing environment that, for now, remains favorable.
Image source: Getty Images.
Looking ahead
The auto sector is still very attractive to invest in, auto parts stocks in particular. They've sold off heavily as automakers struggle to meet production expectations. However, if demand remains strong and pricing does too, it will only be a matter of time before production ramps drop into significant revenue growth in the auto sector. However, be prepared for some potentially bad news in the near term (red flag) even though the underlying fundamentals (green flag) remain positive for the long term
