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The Automotive Industry has come a long way in its recovery from the downturn in 2008-2009. Industry production/sales and earnings accelerated sharply in 2010 and 2011, with many original equipment manufacturers (OEM) and auto parts suppliers posting record results. However, the industry began facing some challenges in late 2011, with increased pressure heading into 2012. Automotive companies maintained relatively decent results through the first half of 2012, despite notable headwinds from weakness in Europe and some softening in emerging markets.  However, the overall environment became more difficult in the second half of 2012, with further deterioration in the European market.

Indeed, although automotive OEM and supplier results were mixed, with some better performers, the overall sector showed increased signs of weakness in the back half of 2012.

One of the core industry themes in 2012, which should remain highly relevant in 2013, has been the contrast between strength in the North American market and weakness in Europe. On the one hand, the U.S. automotive industry strengthened over the course of 2012. The domestic market has continued to perform very well as it remains in the midst of a cyclical recovery, with an overall upward trend.  Strong sales results in the later part of 2012 have helped reinforce investor confidence in the domestic market. Indeed, the seasonally adjusted annual rate (SAAR) of light vehicle sales eclipsed the 14 million level at the start of 2012, and stayed above this range throughout the year, with the exception of a slight dip in May (13.7 million). Notably, the September SAAR reached 14.9 million, which at that point represented the highest level since 2008. This was followed by an impressive November result, as SAAR climbed to 15.6 million, boosted by Hurricane Sandy-driven demand.

In contrast to the strengthening U.S. automotive industry, the European market continues to deteriorate. The weak environment in Europe has been a significant headwind for automotive companies, though some have managed better than others. The outlook for the region remains highly uncertain, as production/sales declines haven’t shown any signs of slowing. In fact, European sales trends continued to decelerate near the end of 2012. Moreover, the weakness has spread across Europe to regional markets that had previously held up better. The production cuts have resulted in excess capacity across the industry, and most OEMs and suppliers have been forced to undertake substantial restructuring, with a focus on capacity reduction.

Investors have become increasingly cautious regarding the automotive industry. Both OEM and supplier stocks were among the strongest performing sectors in 2011, and maintained solid overall momentum in the earlier part of 2012. However, volatility picked up for the broader group of stocks throughout the course of 2012, with most of these shares underperforming the market for the full year. Although there is plenty of uncertainty, both in the domestic market and abroad, we look for similar trends in 2013. The domestic market should continue to perform well, but with more moderate results. Both sales growth and profitability should decelerate, with SAAR likely stabilizing near the recent high-14 million range. Meanwhile, it remains to be seen at what point the European market will bottom out, but clearly it’s still on the decline. Even with the sharp decline in 2012, European sales will still probably drop in the low-to-mid single digit range in 2013. Moreover, additional capacity reduction may be needed, which should weigh on the bottom lines of automotive companies.  In addition to production and sales declines, profitability may take a hit from a weaker sales mix. Indeed, there were already signs in the later part of 2012 of a mix shift away from premium vehicles in many European markets. This mix shift could affect both the OEMs, in terms of pricing/profitability, and suppliers, with lower average content value per vehicle. Meanwhile, results from emerging markets have been mixed, but softer overall. Stimulus initiatives have helped to a degree in some of these regions, like Brazil, but underlying demand appears to have weakened. Latin America, which has become an increasingly important market, should face pressure in 2013.

Although the near-term industry outlook will likely be more challenging, there should be opportunities for investors. Valuations are pretty attractive across the industry, so investors can focus on companies that are better positioned to perform in this challenging environment. Notably, there was a greater divergence in sector stock performance in 2012, and we expect this trend to persist in 2013, with a clear separation between better positioned and weaker positioned OEMs and suppliers. Companies with strong global diversity, and balanced exposure to emerging markets should perform better. In the auto parts group, there are many suppliers that have exposure to secular growth themes, including clean technology and safety, which make them stand out as investment candidates in the current environment.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.