TheChek News Flow

Upgrading Nissan, Renault & PSA to Outperform

Highlights

It's early 2014 and all around the world we can see cheap auto stocks. But do low valuations offer an opportunity in autos – or do they just mean earnings have peaked? The 'classic' time to buy auto stocks is when sales volumes are low and earnings multiples are nearly infinite – not when demand is strong and
margins high. Looking around the globe, there are not many regions where sales are weak and earnings are poor – with the possible exception of Europe. In this report we take a comprehensive look at auto sector valuations across the globe. We review WHERE valuations are lowest, consider WHY stocks are cheap and discuss WHETHER there's a case to be made for buying the auto sector. Our conclusions? We're probably near the top of the cycle for margins in many regions, including the US and China. Most higher-margin stocks on low PEs are probably value traps. But Japanese autos probably still have earnings momentum thanks to currency tailwinds. Mass-market European autos probably do offer some deep value – albeit at high risk.

We are making some recommendation changes on the back of valuation – and hopes of forthcoming earnings momentum. In Asian autos, we upgrade Nissan to Outperform. Amongst the Japanese, Nissan looks stand-out cheap, trading at a massive discount to peers after 3 profit warnings. With currency continuing to improve and sales trending up, we believe its fortunes will soon turn. In Euro autos, we may, perhaps, maybe, just maybe, be seeing some tentative signs of light at last – particularly in Spain. We upgrade PSA to Outperform – while the post-Dongfeng capital structure (and therefore share count) remain unclear, the sensitivity to better European sales is huge and we believe new management will find many opportunities for improvement. It may take a while – and consume some capital – but we believe PSA's situation is salvageable. We also upgrade Renault to Outperform – while we remain worried about Renault's BRICs exposures, our new Nissan valuation plus European hopes drive a more positive stance.

Σ Cheap stocks everywhere. Everywhere we look, in almost every region, we see cheap auto stocks. Everywhere we travel we're asked why they're so cheap and whether they will re-rate. We concur multiples are low – it doesn't take much work to see that – the PE multiples stand out on any screen. But low PE multiples mostly reflect high margins. The market is simply telling us that it doesn't believe this level of profitability is sustainable. This caution is understandable given the historic track record of the industry and the cyclical and volatile nature of returns. But is the current caution going to be proven
correct or are we in a new and sustainable era of profitability – or even ongoing profit growth – meaning low valuations offer an opportunity?

Σ There's a reason why stocks are cheap. In each region, there are simple and logical reasons why autos are cheap. For the cheap German autos, the market knows China is driving profitability and worries super-normal pricing and mix are not sustainable. For the cheap Chinese stocks themselves, the same
issues apply, as well as concerns about SOE behaviour and long-term competitiveness. For the cheap US autos, the market worries that the changes in pricing behaviour and profitability after government-led restructuring are not sustainable – and Japanese competition is again intensifying. For the cheap Korean autos, the market worries that they got lucky when the Japanese were on the back foot and will now face pain as the Japanese roar back. For the Indian car stocks, they don't actually look that cheap (Tata apart – but it suffers the same China-related concerns at JLR as the Germans). For the French and Italian autos, they're not cheap on earnings but they look cheap on metrics like price-to-book or EV/Sales. However, a Euro zone recovery remains more of a concept than a reality at present – and the long-term prospects for the European OEMs are far from clear. That leaves the Japanese stocks. While they are some of the most expensive stocks globally, that's probably for a reason, as the Yen may continue to drive their market share and margins higher.

Σ A global comparison of auto stock valuations. In this report we look at 20 OEMs globally to compare and contrast valuations. For the 13 stocks that we cover, we use our forecasts. For the remainder we use consensus forecasts. We adjust for obvious accounting differences between IFRS and US and Japanese
GAAP (such as R&D capitalization policies) and then compare valuations on EV/Sales, EV/IC, EV/EBITDA, EV/EBIT and P/E multiples. This exercise shows the multitude of cheap auto stocks across the globe but highlights that the cheapest can be found in Korea and France – with the most expensive in
India. German, US, Japanese and Chinese stocks sit somewhere in between.

Σ Where are the stocks cheapest? Where are the opportunities greatest? Auto stocks normally only look cheap on earnings metrics towards the top of the economic cycle – in tougher times most automakers make minimal or negative profits so the multiples look high. Most seasoned stock market observers will tell you that the time to buy autos is when they look expensive – not cheap – in the hope that the economic tide will turn and top line recovery will power up earnings. But heading into a year when only some of the world's regions are enjoying strong car sales (e.g. China and the US) while others struggle (e.g. Europe) and earnings should still remain robust, is there still a case to be made for autos? Do some auto stocks still offer good upside? Can the sector still outperform? We doubt very much that adding fresh money to autos right now will deliver tremendous performance like it can early in the cycle – but perhaps there are still investment opportunities left in the sector. Earnings momentum (which is always hard to forecast) usually trumps valuation (easy to see for everyone) in the auto sector. But we think there's some logic in recommending stocks where expectations are low and multiples are modest –
particularly on non-earnings metrics such as price to book and EV/Sales. Cheap stocks can obviously work well if their fortunes begin to improve.

Σ Japanese autos have momentum – and Nissan looks too cheap. Amongst our coverage we see two areas of opportunity. First, we think the Japanese industry will continue to outgrow the broader industry – with the Yen move and a number of years of restructuring combining to drive a virtuous cycle of improved competitiveness, volume gains, profit growth and reinvestment. We believe the Japanese will be share winners for a number of years from here. For most Japanese stocks, share price moves and multiple expansion in 2013 mean valuations arguably now largely reflect this positive outlook. Except for Nissan. We believe Nissan's fortunes will soon improve and are upgrading the stock to Outperform with a JPY1,200 PT.

Σ We see value potential in French autos – and possible signs of light in European car demand. We spent 2013 dragging our heels about the idea of a European car market recovery. While PSA and RNO and Fiat rallied, we kept asking, "Recovery, what recovery?" – as there was very little evidence of any
stability – never mind improvement – in European sales (outside the UK) in the first 9 months of 2013. But in the final quarter we believe there were some early signs of green shoots. It's patchy and far from sufficient to rescue the industry. But Spanish sales ARE trending up. Claims this is just due to scrappage incentives are no longer convincing – there is something more profound going on. With Spanish macro data – including employment – improving, we believe we may be seeing a turning point. France and Italy look less obviously encouraging, but sales did improve very slightly in December. A SAAR analysis suggests a slight improvement in Spain, France and Italy in the last 2 months. A recovery isn't certain at all. But stocks are not pricing one in. While we missed the rally in PSA and Renault in 2013, we do not believe we're "too late". If there ARE any proper signs of life in Europe, these stocks can go higher. On balance, with the stocks this cheap, we think the risks are to the upside. We are upgrading PSA to Outperform (from Market-perform) and Renault to Outperform (from Underperform). Renault's value is dominated by its 43% stake in Nissan so our up-rated recommendation is significantly influenced by our more positive stance on its Japanese partner.

Σ Nissan – Upgrading to Outperform (PT JPY1,200). Nissan is the only Japanese auto within our coverage and is on much lower multiples than its main peers. Admittedly it has traded on a discount to Toyota and Honda for many years – perhaps since foreign managers descended on Japan in 1999 to turn
it around. But the discount has widened in the last 18 months as Nissan has misfired and blown itself up with 3 serious profit warnings. But it is now trading on just 30% EV/Sales, c.2.5x EV/EBITDA – as cheap as Hyundai and cheaper than all other auto stocks on EV/EBITDA. On EV/Sales it is cheaper than
all other global OEMs except the Koreans and French (cheaper even than Fiat or GM). On both EV/Sales and EV/EBITDA it is trading at less than half the multiples of Toyota. Yet it has massively favourable JPY tailwinds, highly competitive engineering, manufacturing and product and is working hard to fix its many execution challenges. We believe its fortunes are soon set to turn. We are raising our volume and currency assumptions (with the JPY at 104 to the US$) – driving our forecasts for 2014/15 and 2015/16 to levels 13% and 12% above consensus. Our new price target is based on EV/Sales of 40% and a PE of
10x (2014/15).

Σ Renault – upgrading to Outperform (PT of €75). We are upgrading Renault from Underperform to Outperform – raising our PT €75 to reflect our higher Nissan target price as well as higher estimates for core Renault earnings thanks to better volume assumptions in both Europe and emerging markets. Our previous cautious stance on Renault was driven by fears about its extensive BRICs exposure – where slower markets and slumping currencies are creating challenges. Many of these markets have deteriorated since our downgrade and the impact of currencies was seen vividly when Renault reported Q3 sales. However, our worst fears for emerging markets have not materialized and we note that Renault continues to outperform in market share terms in many of these territories. Furthermore, Renault has achieved surprisingly strong volumes in Europe in recent months (it is second only to Peugeot in terms of Spanish
and French market exposure and has outperformed in both) and is well positioned if Europe turns up in 2014. Finally, as the owner of 43% of Nissan, it is heavily geared in valuation terms to a Nissan revival, which we believe is likely (although the cash value of Nissan will remain its dividend stream, not its market capitalization). Our new price target is based on raising the value of Renault's core auto business to 10% of sales (arguably generous) and with the Nissan stake at a 15% discount to our new PT value.

Σ PSA – Upgrading to Outperform (PT of €15). PSA was the best performing European auto stock of 2013 despite its travails. But ignore that – it simply went from having a market capitalization of almost nothing to a capitalization that's still pretty modest. PSA is also widely recommended – others have had a
go at this name already. But in the last two months the stock has blown up as management have abandoned various targets, sought large scale Chinese investment, accepted more government involvement and as GM has abandoned ship. But we expect many of these moves to bring in capital and to buy PSA time. As for GM's departure...well, it wouldn't be the first time that GM has been a contraindicator, would it? We see potential at PSA. We are intrigued by the company in its current situation. It is logical that PSA is in difficulty given its European focus and the deeply depressed nature of its main markets. But PSA is doing WORSE than its fundamentals would suggest. Its engineering and product
range are still very strong. It has continued to invest heavily in new technology through the crisis (unlike some peers). It SHOULD be doing better than it is in market share terms. It COULD take actions to reduce cash burn – with product and technology that is this fresh (and vastly better than many
competitors) it can cut spending for two years with limited ill-effects. It also still has clear structural cost reduction potential (government obstacles not withstanding). People ask what new CEO Carlos Tavares can do? The answer is: plenty. PSA has many financial risks and it is not clear what the capital structure will look like after the Dongfeng deal (which has obviously yet to be confirmed). But we think the risks are to the upside, especially if these very early signs of life in car sales in Spain and France turn into something more substantial. Our new price target is based on raising the value of PSA's core auto business to 10% of sales (clearly generous given it is burning cash – but fortunes may change) with Faurecia in at market value and with a €3bn capital raise assumed at a 20% discount.

Σ German autos – value traps? Turning to other regions of the auto industry, what to make of powerful German automakers trading on modest multiples? PEs of around 10x and EV/Sales of 40-50% hardly look that demanding do they? We remain full of admiration for these companies but the problem we face as stock analysts is that earnings appear to be going precisely nowhere. Margins and cash flow – turbocharged since 2010 by China – both arguably peaked in 2011. Since then, Chinese profit per unit has probably begun to moderate, US growth has slowed, currency has become slightly less favourable and spending has climbed. European profitability remains problematic. An improvement in European car demand may help a little – but these companies are not nearly as sensitive to Southern Europe as the French. In fact the Germans probably make more money in Southern China or even Southern California than they do in Southern Europe. While we remain optimistic on Chinese unit sales growth, absolute profit growth from China may be difficult to achieve (mix, pricing, currency, localization). We are worried that German autos are a value trap. We continue to rate BMW as Outperform (PT €100) as we see it as best-in-class, with the lowest expectations and the lowest cash multiple valuation. But it's a defensive choice and is hardly going to make anyone rich (apart from the Quandts). We are also raising our price target on VW (to €200 on both classes) to reflect a more positive European market outlook (so higher VW, Skoda & Seat values) and a more generous China JV valuation. VW would obviously benefit from a European mass market recovery – although not to the same degree as the French Chinese autos – not that expensive, but facing slowing growth. Chinese auto stocks – at the centre of the global industry's growth – do not look excessively expensive. PEs that average 9x are not that demanding given the growth potential – although the stocks look more expensive on EV/IC (price to book) and EV/Sales – as their high margins help explain their modest PE multiples. But the Chinese
OEMs are not really an appetizing bunch of companies. Overall profitability in the industry is probably "too high" and unsustainable – most notably exemplified by Great Wall, with its Ferrari-beating margins. Capacity will catch up with demand growth. Furthermore, the SOE names have governance issues and two of the three are partnered with Japanese OEMs that have specific challenges in the Chinese market. While we expect Chinese unit sales to grow by c.10% in 2014, we doubt earnings will grow by much more – buying these stocks at a time of more modest profit growth does not look that compelling. Brilliance remains our top pick – although it is not a cheap stock on near-term earnings.

Σ Indian autos – surprisingly expensive. Despite seeing domestic industry volumes go into decline in FY2013/14 (-5.3% YoY through April to November) and despite the market having poor overall profit potential, Indian cars stocks – Tata, Maruti, Mahindra – have remained largely unscathed, and have
traded on valuations in line with historical averages. Since sector valuations fell to a low of just 9.7x forward earnings in August 2013, multiples have actually expanded on hopes of a cyclical recovery while YoY volume declines moderated (although November and December were weak months). Relative valuation fell during 2013. Starting at 0.95x versus the MXAPJ, relative valuation of the Indian auto OEMs fell to 0.79x in August, and ended the year on 0.89x. The average forward earnings multiple of the three Indian OEMs finished the year on 11.8x forward PE. Tata is cheaper than peers, despite having much better global exposure. Relatively to the MXAPJ Index, which was flat during 2013, relative
performance of the Indian auto stocks was +13%. Tata (+20%) and Maruti (+18%) outperformed Mahindra, which was +1% during 2013.

Σ US autos – we are probably at peak earnings. The US is the brightest spot in the global economy, car sales are booming and the domestic OEMs are all thriving, right? That may all be true but it doesn't mean the US autos are that interesting. In our view, domestic auto earnings are probably near peak. The SAAR is near 16mn and while it may climb to 17mn, that'll take some time and only represents 6% growth. Competition is intensifying from the Japanese – who are all using price as a weapon, one way or another. Most segments are more fragmented than they were 5 years ago, due to the incursions of the Koreans and
Germans. Capacity is climbing again. While pick-up sales probably go higher (these are the single most important drivers of US automaker profitability), we believe industry profitability has peaked and things get trickier from here. Ford brought a dose of reality to proceedings last month when it warned US profits would fall in 2014. It won't be alone, in our view. Amongst our coverage, we believe Chrysler may struggle to grow profits meaningfully in 2014 despite the much-delayed but now underway ramp up of
the Cherokee.

Σ Korean autos – cheap but probably in a stall? Korean autos look very "cheap", trading on modest EV/Sales multiples and single digit PEs. But we believe there are good reasons for the market's caution. The Japanese were out of the game for a period but are now well and truly back – and are causing the Koreans trouble in the US, have reversed most of their share gains in China and are renewing their efforts in various other South East Asian markets. Hyundai and Kia also have important positions in emerging markets such as India, Russia and Brazil and are facing challenges in all these places. Korean autos look
like value traps to us in 2014.


Investment Conclusion:

We have a Neutral stance on the European auto sector – but perhaps there are signs of green shoots. The key call in European autos is whether we are going to see a genuine European market recovery. The prospects for significant profit growth from outside Europe look dull – China profits may inch up, but not
dramatically, while we believe US earnings have peaked. So it is all about the home markets. After 5 years of very difficult conditions in Europe, is there any reason to believe that demand can improve from here? We've been cautious for the last two years but we acknowledge that there may now be some signs of green shoots. The UK continues to improve. Germany may be slightly better. But most important, it may be the case that Spanish demand is turning. Even France and Italy performed slightly better in December (although it may have been an end of year registration push by OEMs). The European SAAR appeared to trough in
2013 at c.11.5mn units, but the SAAR in the final two months crept back towards 12mn. Perhaps it will be a false dawn, but the upside for Euro-focused OEMs is material if demand trends upwards in 2014 and 2015. Profits from higher sales in Europe will be meagre – but higher production would drive better cash flow
(due to stretched payable terms). We are upgrading PSA to Outperform (PT of €15) as well as Renault to Outperform (PT of €75). We continue to rate BMW Outperform as the best-in-class German OEM with the most modest cash-based
valuation and lowest expectations. We have a Neutral stance on the Chinese auto sector. Chinese car sales growth surprised in 2013 and we expect further growth in 2014. However, we expect growth rates to moderate in future years – when they
will collide with large increases in production capacity. Margins in the Chinese market are far above industry norms but must surely fall in the medium term. Direct government financial assistance appears to be playing a role in China's fast increasing capacity, which will ultimately lower returns. Within the group, we find some stocks more attractive than others. We rate Brilliance (HK$17 price target) and Dongfeng (HK$17) Outperform. We rate Great Wall (HK$36) and GAC (PT raised to HK$8) Market-perform. We rate Geely (HK$3) Underperform. We cover one Japanese OEM – Nissan. We are upgrading Nissan to
Outperform with a PT of JPY1,200.