SECTOR SCOPE by James A. Anderson August 30, 1999

Investors, Cut Your Engines
Despite booming car sales, auto stocks are lackluster, as analysts anticipate an eventual downturn. Some parts makers might be better bets

Itís an understatement to say that demand for automobiles is strong: The '99 models have barely sat in the showroom long enough for the paste beneath their price stickers to dry. That helped both General Motors Corp. (GM) and Ford Motor Co. (F) turn in second quarters that surpassed Wall Streetís expectations.

And yet, the stocks of the domestic Big Two and of their half-brother, DaimlerChysler (DCX), are parked at valuations so low that their price-earnings ratios are less than half the average for the overall market. Shares of auto-parts makers, whose fortunes mimic the ups and downs of the car makers, are languishing too. Put one and one together, and it might seem like the perfect time to snap up under-appreciated auto shares.

It isnít.

No, the jubilee at your local dealership isnít about to end. Consumer confidence and a healthy economy have teamed to ensure that demand remains high. If North American auto sales continue their pace, theyíll likely break 16 million this year, perhaps even besting the record of 16.4 million set in 1986. Sales may tail off next year, but not terribly so, at least according to estimates by J.D. Power and Associates. Bob Schnorbus, its director of automotive analysis, looks for sales of light vehicles -- compacts, sedans, sport-utility vehicles, and vans -- to slide slightly to 15 million or so units in each of the next two years. "That's a comedown from 1999, but those arenít figures that would leave any auto executive feeling sad," says Efraim Levy, automotive analyst for Standard & Poorís.

PROBLEM ONE: EXCESS CAPACITY. Instead, the lack of exuberance over auto stocks reflects a fear on Wall Street that the earnings gains from an eight-year auto boom are about to come to an end. "The U.S. demand picture is as good as it gets," says Merrill Lynch analyst John A. Casesa. "We believe earnings growth will be increasingly difficult to come by at this high point in the cycle."

Adds ING Barings analyst Michael Pak: "Right now, we donít see a catalyst for earnings growth in the sector." And what goes for the big auto makers goes for auto-parts stocks as well.

The biggest problem for the auto group is excess capacity. North American production capacity exceeds even the current high levels of demand. Indeed, even though Detroit slashed capacity 7% from 1990 to 1998, Merrillís Casesa points out that capacity in transplant facilities set up by overseas automakers has more than doubled over roughly the same period.

Thatís enough to present both Detroit and foreign producers with a difficult choice: Make price concessions, or risk losing your slice of the market. Witness the lackluster second-quarter earnings announced by DaimlerChrysler at the end of July. The bi-continent conglomerate not only fell well short of the Street's profit projections, it also hinted that results could remain muted, though it has softened that prediction somewhat. The culprit, in part, are the incentives car makers are suddenly offering to clear their lots.

FALLING PRICES. Industry numbers show that Daimler isn't the only manufacturer to sweeten its song to consumers. Dealer incentives are up 12% by some estimates, to $1,500 per vehicle. The manufacturers are even finding that they have to cut deals on SUVs, whose profits have bolstered the auto business. "Incentives have been eating at small-vehicle margins for some time," says JD Power's Schnorbus. "Daimler Chryslerís problem was that they began needing them for the Grand Cherokee, too."

Itís little wonder, adds Schnorbus, that average car prices are declining, and could slide as much as 1% annually for the next two years. As a result, Wall Street has wasted no time factoring expectations for limited earnings growth into the prices of auto stocks. Year-to-date, the car makers, as measured by a Standard & Poorís index, are down 6% -- including a dive of nearly 10% in the most recent quarter alone. Auto-parts makers, meanwhile, have lost 3% this year -- including 8% in the past 13 weeks.

While Augustís sell-off hasnít added to the allure of auto maker stocks, it has created some bargains in the parts sector. One may be Meritor Auto (MRA), which grinds out equipment for heavy-duty trucks and commercial vans. It's also a peripheral E-commerce play, since Internet sales have prompted package delivery companies to expand their fleets, says Standard & Poorís Levy. Demand for big rigs was up nearly 30% year-over-year through July, according to Wardís Automotive, which means that Meritor has been more than busy filling orders for axles, brakes, transmissions, clutches, and drivetrains. Meritor, which was spun off from Rockwell International in late 1997, has posted an 18% profit increase during the first three quarters of fiscal 1999, and Wall Street expects its earnings to rise 13% annually over the next five years.

Levy says an easing in truck sales would actually benefit Meritor, which has doled out overtime pay to keep pace with demand. All the same, the stock is mired at a price-earnings multiple below eight times earnings. Levy says the stock deserves to trade at 10 to 11 times his fiscal 2000 estimate of $3.10 a share, which translates into a target price for the stock of as much as $34.10 a share, compared with its Aug. 27 close of $20.94.

AUTO FUNDS: UGH! Another parts maker, Dana Corp. (DCN) has suffered a low p/e because of Daimlerís latest earnings release. Dana is a play on consolidation within the parts industry, a trend analysts say will continue as auto makers look to slash costs.

Traditionally a supplier of parts for original equipment makers, or OEMs, Dana moved last year to bolster its position in the aftermarket for replacement parts with its purchase of rival Echlin. Value Line analyst Clifford T. Walsh estimates the company has thus secured business worth more than $700 million annually to its top line over the next decade. That should spur average annual earnings growth by 11%, according to Value Line estimates. S&Pís Levy says that Danaís shares, now stuck at p/e of nine, should fetch 11 to 12 times his $4.78 a share estimate for the year 2000, pointing to a target price of $57 a share vs. the Aug. 27 close of $43.50.

As a cyclical sector, the automotive group hasnít attracted a lot of pure-play mutual funds. The most notable is Fidelity Select Automotive (FSAVX). Fidelityís offering is up a paltry 0.2% so far in 1999, and finished 1998 with a 4.9% total return. Over the past three years, the fund has averaged a 9.42% annual total return, according to Morningstar.

James Anderson teaches journalism at the City University of New York

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