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Stocks  | September 23, 2019

No one wants to buy auto stocks these days. It doesn’t feel smart to buy cyclical stocks at the end of a long-running economic expansion. That reluctance, however, could cause investors to overlook one of the most-profitable niches in the global car market: U.S. light trucks.

Americans love their trucks. More than 70% of new vehicles purchased in the U.S. are built on truck platforms. SUVs, for instance, count as light trucks as far as the industry is concerned. That is good news for General Motors (ticker: GM) and Ford Motor (F), the largest makers of pickup trucks and related vehicles.

“Pickup truck industry fundamentals remain very strong,” Citigroup analyst Itay Michaeli said in a Thursday research report. He tracks the performance of different truck models for Citi clients. “Our data generally looked positive for GM—granted, GM is currently facing strike-related risk.”

Ford, on the other hand, is feeling the pinch from more competition. Michaeli notes that new-truck pricing and product mix at Ford are down a little recently as rivals try to take share from Ford’s popular F-150. (Mix refers to the trim level of trucks. The more bells and whistles on a vehicle, the higher the price and the better the “mix.”)

More competition sounds bad, but trucks in the U.S. are nothing like cars. For starters, the top three truck makers in America—Ford, GM and Fiat Chrysler ’s (FCAU) Ram brand—have about 75% of the U.S. light-truck market. In fact, the stand-alone U.S. truck business looks more like an oligopoly—a fancy word for an industry with a limited number of producers. That, according to conventional wisdom, leads to better profits by limiting competition and giving the existing producers cost benefits through higher scale.

The total car business isn’t nearly as concentrated as U.S. light trucks. Three of largest car companies in the world— Volkswagen (VOW.Germany), Toyota Motor (TM) and GM—have about 30% of the global automotive business.

It could be that the concentration leads to better truck profitability. GM and Ford make more money selling trucks. It is difficult to get precise data—truck profitability is a closely guarded secret—but there are hints.

“Products like F-series, Transit, Explorer, Ranger, among others, make up over 150% of our total company [operating profit],” Jim Baumbick, Ford vice president of enterprise product line management, said at an April Investor conference. Because other products aren’t profitable, trucks, in aggregate, account for more than 100% of total company profits at Henry Ford’s namesake company.

So if trucks are so great why won’t investors pay up for Ford and GM stock, which trade for 6.5 times and 5.8 times estimated 2020 earnings, respectively?

“Auto stocks tend underperform 70% of the time U.S. auto sales are falling,” Wolfe Research analyst Dan Galves said. “That ends the conversation for a lot of portfolio managers.” U.S. auto sales are falling, albeit slowly. The pace of sales in the U.S. this year works out to an annual total of 16.9 million units. That would be down less than 2% from 2018 levels.

Still, Wolfe rates GM shares Buy with a $59 target price. “GM has gotten rid of its European business and the Chinese business is solid,” Galves said. With the European exit, GM isn’t far off from becoming primarily a North American truck business.

Calling GM just a truck company might be too much for investors to accept. What’s more, there is some concern that truck sales will soften if interest rates rise or unemployment jumps. Trucks, on average, are more expensive than cars.

“I think it’s fair to say that we’ve all been a little bit surprised at how strong [average truck transaction prices] have grown over the last 10 years post the financial crisis,” said Joseph Hinrichs, president of Ford’s automotive division, when addressing a “peak truck” question at a June investor conference. “So far, people continue to want additional [truck] capability and they’re willing to pay for it, which is great to see.”

Even if truck prices hold up, there is the problem of an auto worker strike at GM. That is another reason investors have been avoiding the sector recently.

“If it extends into next week it becomes problematic,” Seaport Global analyst Michael Ward said. “Costs escalate, especially for the [union]. It could lead to an unfavorable settlement longer term. I think it also alters the good relationship the two sides have had for more than a decade.”

Yet another reason investors are avoiding Ford and GM stock, according to both Ward and Galves, is that they aren’t convinced profits will hold up in a downturn. Both car markers say things are different this time, that cost-cutting since the financial crisis means the companies can earn money through a recession. That idea, however, hasn’t been tested. Despite recent declines, car sales have been rising, or stable, for a decade.

Unfortunately for Ford and GM shareholders, the truck narrative doesn’t appear to drive stock valuation. Maybe in the future, as both companies pivot toward trucks, valuation multiples can improve.

GM stock is down 2.8% since the UAW strike began, worse than the 0.5% drop of the Dow Jones Industrial Average over the same span. Over the past year, GM shares have returned about 10%, while Ford stock has lost about 1%. The Dow, for comparison, is up about 5% over the past year.

Analyst Rod Lache, the primary analyst covering GM at Wolfe, rates shares Buy. Galves is on the automotive research team at Wolfe covering other stocks such as Uber Technologies (UBER).

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