Where are the opportunities in a disrupted US auto sector?
Worldwide automobile production is struggling to keep up with demand, mainly due to shortages in semiconductors and supply chain disruptions.
Geopolitical unrest is causing further declines in production estimates and applying the most pressure to European output. Russian auto production is expected to collapse. German auto original equipment manufacturers (OEMs) are facing factory slowdowns due to suppliers having manufacturing exposure to Eastern Europe.
Meanwhile, US production estimates suggest a weaker first quarter, with a steady improvement throughout the remainder of the year. China production estimates remain fairly stable for now but Covid is increasing the risk of future shutdowns.
In previous cycles, the explanation for severe production cuts could have been falling demand from the end consumer, normally related to recessionary environments.
This cycle is very different because demand across the world is strong, particularly in the US. Right now, supply side variables are driving the shortfall in production. While the semiconductor bottlenecks are well known, the conflict in Ukraine is further pressuring many other critical components.
Shortages are causing US car prices to rise
The imbalance of supply and demand is creating a sharp rise in new car prices in the US and also causing used car prices to climb. These price hikes are contributing meaningfully to the elevated inflation numbers in the US.
Car dealers normally keep new cars on their lots for an average of 60 days. Inventory days are now between 10 to 15 days and are not predicted to return to normal until 2024.
Steady state demand for new vehicles can be tracked by looking at scrappage (how many cars are scrapped each year) plus the number of new licensed drivers. When looking at this statistic versus new car sales (Figure 2), it is easy to see how much sales fell short in 2020 due to production challenges.
Scrappage rates declined in 2021 as drivers kept cars on the road for longer, evidenced by the rising average age of the cars on the road (now more than 12.5 years). There is unmet demand of almost five million vehicles in the US and it will take years of production increases to fill that demand.
Select suppliers and dealers poised to benefit
Considering the amount of auto production required to catch up with the prevalent strong demand, we believe there are opportunities to invest in certain US small and mid cap companies that are poised to reap the rewards as inventory replenishes.
Most US car manufacturers are either too big for investors focused on small and mid cap companies, or too speculative. Some resemble EV (electric vehicle) startups, most of which came public via SPACs (special purpose acquisition companies).
Instead, we believe the more favourable risk-reward scenario exists in auto car parts suppliers, who will benefit from increasing production.
In addition, auto dealers who continue to benefit from pricing, with low discounting in a tight supply environment, and a refocused online strategy for used cars could also benefit.
Companies that supply parts to any brand or type of vehicle will see outsized benefits when production inevitably recovers.
For example, certain US companies have unique technologies addressing the growing demand for EVs, as well as opportunities to increase their applications in newer, non-EV vehicle models. As production increases, these suppliers should also see penetration gains that in turn should drive faster growth than the broader industry.
While there have been industry concerns about the longer term viability of the dealer model, we think most global manufacturers will retain a dealership distribution structure.
The US dealer parts service network is highly strategic and larger dealer networks (mostly public) are now extending their strategy into online sales with home delivery. This should help take share from less capitalised independent dealers over time.
Summary
The global auto industry is off kilter. Demand is and has been strong, especially in the US, and supply has been constrained.
Inventory of available new cars for sale is at historically low levels and even if the consumer becomes pressured, we believe production increases will persist for a number of years. The supply dislocation has also allowed larger dealerships to broaden their used car business through online initiatives.
We prefer to capitalise on this opportunity by focusing on suppliers benefiting from innovative technologies that remain relevant as the world pivots towards more EVs. We also like dealers who benefit from better pricing amid supply constraints and leveraging scale to further grow their used car franchises.
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