The Daily Interview: Fast and Furious Car Sales, or Slow and Sluggish? - TheStreet

Aside from the safety hearings and the ongoing public relations war between

Ford

(F) - Get Report

and

Firestone

over safety issues concerning Ford Explorers outfitted with Firestone tires, the automotive industry has been having a surprisingly good time lately.


Domenic Martilotti
Automotive Analyst,
Bear Stearns

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Despite slowing consumer spending and rising gasoline prices, automakers are enjoying fairly robust sales year to date, primarily due to generous incentives being offered by carmarkers.

Today's Daily Interview checks in with

Bear Stearns'

automotive analyst Domenic Martilotti to see how the remainder of the year is shaping up for carmakers and what will be driving their growth going forward. Martilotti thinks the

Fed cuts will be a boost to auto manufacturers, especially for their financing activities. Auto manufacturers are usually seen as good cyclical plays, but it's time to hold off for a while because many are richly valued right now, with the exception of Ford, he says.

TSC: There seems to be no end in sight in the Ford-Firestone debacle. What are the key issues and where does Ford stand?

Martilotti:

The key issue is how much data each side is using, which inevitably have some biases, and what the quality of that data is. Until last week's congressional hearings, each side had been pitching to the press in a mudslinging contest to some extent.

The biggest problem is that there are no real industry standards of how to measure the quality of tires and failure rates. Even with the data that we have, it's hard to determine how the tires can break down, or whether it was the dynamic between the tire and the vehicle that's contributed to the failures.

The answers to all this will eventually come from the

National Highway Traffic Safety Administration

, which is a slow-moving government organization. Here we are 10 months later, and it still has not come to conclusions to what the problem was with the tires from last summer.

TSC: What are the metrics you use to gauge the health of the automakers and that of the industry as a whole?

Martilotti:

If you look at the companies individually, their cash positions are pretty important, as well as some traditional balance-sheet items, given the fact that their credit rating is important to the companies' ability to compete in the business. They are huge borrowers and lenders for financing their car sales: They finance their dealers on the wholesale level, but also help the average guy pay for his car. If it's more of a competitive position, one car company cannot afford to be worse off than other competitors

in terms of credit rating. The

Big Three

automakers all have an A rating.

Right now there is the talk of downgrade, especially given the Firestone deal, but the carmaker can't afford to be at a disadvantage in terms of its ability to borrow. The numbers resulting from a downgrade would be staggering. Aside from the financial institutions, the automakers' balance sheets are the biggest.

Looking at market shares and key markets are also important. Is the company's margin under pressure in some markets? This is a concern for both Ford and

GM

(GM) - Get Report

, given that these guys make their money in trucks in North America. They don't really have much profit anywhere else. They pretty much break even internationally, and they break even on cars overall.

As you look at their truck business in North America, the foreign manufacturers are adding capacity in that category, and this inevitably adds supply and increases pressure on margins. In addition to that, the overall market is slowing. Having said that, auto sales have been pretty good. But these numbers have been artificially supported because incentives have gone up so dramatically from last year. In the month of May, the incentives for the whole industry were up 30% from a year ago. They are now up to $2,600 per vehicle on average.

It's very tough to maintain market share in a declining market, so incentives are understandable. However, the problem is that the consumers are becoming very conditioned. This is similar to people not buying clothes unless there is a sale. In the auto market, it's like having a continuous sale. The only exceptions are when the vehicle just launched or when there's a healthy demand with people willing to pay above the sticker price.

TSC: What's your outlook for the remainder of the year?

Martilotti:

I think sales will somewhat soften through the end of the year. The wild card is incentives, which carmakers have aggressively been offering. If they want to keep this up, they can put sales pretty much wherever they want to. They won't stop using incentives until consumers stop responding to them. On the truck side, there's plenty of margin to be eroded. On SUVs, they make about $10,000. It's a nice margin they can play with. But on cars they really have no margin to play with. If they don't prop up sales with incentives, sales would go lower. There are such high fixed costs to the business that the company would rather keep the factories running and sell the vehicles.

TSC: What will drive the growth of the industry going forward? Many industries -- such as leisure markets -- are warning of soft sales. How will the carmakers cope?

Martilotti:

You can't really compare leisure goods with cars. While leisure services and goods are optional, people will always need to buy cars. We have already seen that while SUV sales are still growing, the rate of growth is slowing, especially on the full size. The smaller, car-based SUVs are actually gaining popularity. The buyers now are those who have already bought SUVs before, repeat buyers in the market. And those consumers turning away from larger models, probably with gas costs also in mind. The SUV market is still fairly new and will continue to evolve, offering more to the consumers.

Now sport wagons are a growing category in which carmakers are making investments now. They're like your more traditional station wagons but a bit taller. That will be a huge growth segment.

TSC: How will the Fed's interest-rate moves impact the car business?

Martilotti:

We've referred to their ability to use financing to offer incentives. Over the last few years, leasing has been a huge growth element. Leasing has encouraged buyers to go for more expensive cars, which they couldn't afford otherwise. But this has also burned the manufacturers on the back end because they valued the cars higher than they were really worth when they came into the resale market.

What the Fed cuts this year have allowed manufacturers to do is push buy vs. lease, because the carmakers can pass on lower financing rates almost immediately. If the automakers can get through the rough part of the year, which I think is going to be the third quarter, they should be OK. Underlying demand should improve.

TSC: Which automakers would be a good investment now?

Martilotti:

I have an attractive rating on GM and neutral on Ford. With these companies, you are playing the cycle. The problem with the current situation is that we haven't had a down cycle. We have seen only one month of bad sales, which was December, once the economy started slowing down. In the first quarter of this year, there was a trough in production. But the first quarter is usually a weak quarter, and it wasn't quite a cycle.

Also, the stocks reacted too quickly to the interest rates. There is usually a lag. With the tech blowout, people had to put their money somewhere. Everyone moved to the cyclical names early, although Ford has given this back with the Firestone problems. So that's one way of playing the cyclical names.

Another way is the type of value-enhancement move that we have seen in the last few years, as the automakers have spun off a lot of their other businesses. GM's

Hughes Electronics

would be an example, although I don't expect a large premium in that particular case.

Also, you can look at automakers in terms of their valuation relative to their long-term growth. Right now, the stocks are quite fully valued, and there is greater possibility of downside rather than upside surprise.

Ford, long term, is a good company. Right now, there's limited upside because of the Firestone tires. It was trading as high as $30. Now it's around $24, yielding dividend of 5%, so there's some support at these levels. But the stock won't move for some time.