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Domestic Autos Stock Outlook: Steering Through a Rough Patch

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The strong sales momentum witnessed by the U.S. auto industry in 2015 and 2016 did not continue in 2017. However, in 2018, industry sales have been trending higher, helped in no small measure by a positive economic backdrop and dealer discounts. The strong job market and favorable tax measures have boosted consumer demand, which in turn is driving sales.

In the year so far, concerns about high interest rates and growing oil prices have not stopped Americans from splurging on sport utility vehicles (SUVs) and pickup trucks. This has led to strong unit sales of SUVs, crossovers and pickup trucks. In fact, this changing preference, from conventional passenger cars towards spacious vehicles, has prompted automakers to reorient their business strategies. In the changing situation, big discounts are playing a huge role in helping automakers grab a higher share of the market or at least retain their share. However, these discounts are putting pressure on their margins.

Industry players also have to contend with the need to invest in all-electric vehicle (EVs) and autonomous driving technology. In between all these developments, recalls remain an overhang.

Industry Returns on a Bumpy Track

Broader economic growth has not been enough to give market participants confidence in the industry's outlook. With sales already at or near record levels, many in the market suspect that the direction of change in sales will be to the downside going forward. Importantly, the need to maintain sales levels is forcing industry players to offer incentives that eat into margins. The rising interest rate environment is an issue as well. 

The Zacks Domestic Auto Industry, which is an eight-stock group within the broader Zacks Auto, Tires And Trucks Sector that includes companies like Ford and GM, has underperformed both the S&P 500 and its own sector over the past year.

While the stocks in this industry have collectively gained 2%, the Zacks S&P 500 Composite and Zacks Auto, Tires And Trucks Sector have rallied 13.5% and 9.2%, respectively (the blue line in the chart below represents the industry). 

One-Year Price Performance

A Good Value or a Value Trap?

We can look at a variety of valuation metrics to evaluate the industry's valuation picture and all of those will likely help us reach the same conclusion. But given the high capital intensity of the space, the appropriate metric is the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio or multiple. This metric takes into consideration equity as well as the level of debt. Also, this metric is not impacted by differing capital structures and does not take into account the effect of non-cash expenses.

Owing to the industry underperformance over the past year, the valuation picture appears attractive, in comparison to the S&P 500. The industry currently has a trailing 12-month EV/EBITDA ratio of 8.6X, at a discount to the S&P 500’s EV/EBITDA ratio 11.5X. As the chart below shows, the industry has traded as high as 12.7X and as low as 10.7X, with a 12-month median of 11.4X. 

Looking at industry's valuation history relative to the broader market, we find out that the industry traded at a premium to the S&P 500 index from January 2012 through January 2015 and has been trading at a discount since mid-2015. 

Enterprise Value/EBITDA TTM

The chart below compares the industry's valuation picture with its sector. As would be expected, the two track each other fairly closely, though the industry is currently trading at a modest premium to the sector. As the chart shows, the industry traded at a premium to the sector through year-end 2017 and has been trading at a discount this year. 

Enterprise Value/EBITDA TTM

This valuation discussion shows that the group's valuation is attractive. But offsetting this seemingly favorable valuation picture is the long list of issues plaguing the space, ranging from trade issues (the future of Nafta) to the negative earnings impact of discounts.  

Underperformance May Continue Due to Bleak Earnings Outlook

The positive macroeconomic drivers are likely to be offset by operating challenges encountered by the industry, keeping a lid on shareholders’ returns.

The industry's recent stock market underperformance notwithstanding, the more relevant question for investors pertains to handicapping how the industry will perform over the coming weeks and months. 

A good handle on the industry's, and companies', evolving earnings outlook can help answer that question for us.  Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry below shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

Price and Consensus: Zacks Domestic Auto Industry

This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the -$2.61 EPS estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks Domestic Auto industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the loss of -$2.61 per share of the industry for 2018, but how this estimate has evolved recently.
While the consensus loss estimate for the Zacks Domestic Auto industry of $2.61 per share implies mostly a decent year-over-year improvement, the trend in earnings estimate revisions has not been favorable lately.

Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

The consensus EPS estimate for the current fiscal year has been revised 8.8% downward since Mar 31, 2018.

Current Fiscal Year EPS Estimate Revisions

Zacks Industry Rank Indicates Solid Prospects

However, the group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates the possibility of outperformance in the near term.

The Zacks Computer Software industry currently carries a Zacks Industry Rank #101, which places it at the top 39% of more than 256 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry’s rank has continuously improved over the past five weeks.

Domestic Auto Industry’s Long-Term Growth

Since the past month, the group’s mean estimate of long-term EPS growth rate has been decreasing to reach the current level of 8.5%. This compares to 9.8% for the Zacks S&P 500 composite. However, before that, the long-term EPS growth prospects for the industry were better than the Zacks S&P 500 composite index.

Mean Estimate of Long-Term EPS Growth Rate

Revenue growth figure for the industry shows that since the end of 2015, revenues for the group have been increasing. However, gross profit has witnessed a declining trend since the end of 2016.

Revenues – Autos Mfrs-Domestic Market

Gross Profit – Autos Mfrs-Domestic Market

Bottom Line

A closer look at the domestic auto industry brings some interesting facts. Cheap valuation and improving industry rank are some bright spots. Moreover, these two fundamental factors are further bolstered by solid macro economy.

However, several changes and challenges put a huge strain on the profitability of the industry as a whole. The fat discount to sell vehicles corroborates the phenomenon of a recent rise in revenues with strained profits. Added to this, the bleak earnings outlook does not brighten the prospects for shareholders’ returns. Trade uncertainty, particularly the future of the North American Free Trade Agreement (NAFTA) also has a direct bearing on the industry's fture. 

While none of the stocks in our domestic auto universe currently sports a Zacks Rank #1 (Strong Buy), below are three stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).

(You can see the complete list of today’s Zacks #1 Rank stocks here.)

Fox Factory Holding Corp. (FOXF - Free Report) : The stock of this Scotts Valley, CA-based automobile company has gained 18% over the past year. The Zacks Consensus Estimate for the current-year EPS was revised 2.8% upward over the last 60 days.

Price and Consensus: FOXF

Tesla, Inc. (TSLA - Free Report) : The stock of this Palo Alto, CA-based auto company has gained 6.8% over the past six months. The Zacks Consensus Estimate for the current-quarter loss narrowed down from $2.63 per share to $2.59 per share over the last 30 days.

Price and Consensus: TSLA

PACCAR Inc. (PCAR - Free Report) : The stock of this Bellevue, WA-based manufacturer of heavy-duty trucks has lost 12.3% over the past six months. The Zacks Consensus Estimate for the current-year EPS was revised 0.4% upward over the last 30 days.

Price and Consensus: PCAR

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