For more than a quarter-century, Rod Lache has been in the top tier of Wall Street analysts, first at Deutsche Bank and now at Wolfe Research, a New York firm where he is a managing director. His most famous call—that General Motors stock was headed to zero—came eight months before the 2009 bankruptcy of the Detroit auto giant, on which he’d been bearish for years. Institutional Investor has ranked him the No. 1 U.S. auto analyst in every year since 2012.
Barron’s recently spoke by telephone with Lache (pronounced “Lash”), who is based in Florida, and his colleague Dan Galves, a director and senior analyst at Wolfe’s Manhattan offices. In the edited comments below, they discuss automotive trends and some stocks they favor, including, yes, Tesla (TSLA).
Q: What’s ahead for investors in auto stocks?
Rod Lache: The automotive landscape will change dramatically over the next five or 10 years. There are growth opportunities, but some companies will be disrupted. In addition, we’re 10 years into this auto cycle; investors fear a downturn. But historically, some companies have exhibited extraordinary performance as the market was moderating.
Q: How do you find outperformers?
Lache: We like companies that can take advantage of what we call ACES—meaning megatrends. ACES stands for autonomous, connected, electric, and shared. We have four key criteria. First, we look for companies poised for extraordinary growth. Second, we seek those that are resilient because of exposure to a customer or technology that’s doing well, a strong order backlog, or very low operating leverage. Third are companies that can create value through spinoffs. Fourth are those with extraordinary free cash flow.
We see tremendous growth in advanced driver-assistance systems, from autonomous emergency braking to semiautonomous and, eventually, fully autonomous vehicles, or AVs. The market for those technologies is around $6 billion globally, but it will be $50 billion by 2025. And if shared mobility gains just 10% penetration in the U.S.—and the cost of ride sharing declines from $2 to $3 a mile, as it is now, to $1, as we expect—we’ve created a $350-billion-a-year market.'
In electrification, huge things are happening. BVs—battery electric vehicles like Teslas and Chevy Bolts—are still a small part of the market, but their sales are growing rapidly. In 2018, they actually generated 100% of the global industry’s sales growth. Hybrids last year were about 3% of global light-vehicle production. Within five years, they’ll be 24%. As for connected, roughly 15% of U.S. recalls in recent years have been software-related. People generally go to dealerships to correct the flaw. A lot of this eventually will be done over the air.
There also will be a tremendous opportunity for advertisers, online services, and the car makers themselves, from data collected from vehicles and information or entertainment disseminated to autonomous vehicles. Because AVs require no human driver, the number of people in a moving car or sport-utility vehicle who can send texts, read emails, watch movies from Netflix (NFLX), or buy products from Amazon (AMZN) while riding will greatly increase.
Q: Who wins on this new playing field?
Lache: Our favorite is General Motors (GM), a $56 billion market-cap company, as we speak, that owns 75% of Cruise Automation. Cruise is one of the two leaders in developing artificial intelligence for AVs; the other is Waymo [a unit of Alphabet (GOOGL)]. Cruise’s technology could ultimately move into the ride-sharing market. An investment by Honda Motor (HMC) valued Cruise at $14.5 billion.
If Cruise achieves the milestone it is talking about sometime at the end of this year or maybe the beginning of next year—having vehicles driving in a major city with no human backup driver—it will set the stage for them to enter autonomous mobility on demand. It also will boost their value, which could jump to $20 billion, using a conservative estimate. GM’s 75% stake would then be worth $15 billion. So the market is paying $41 billion for the rest of GM. In addition, General Motors has done an extraordinary job of concentrating its business and earning capital where it has strong franchises. It has been proactive in improving profitability.
Q: President Donald Trump’s threatened tariffs of up to 25% on imported vehicles and parts might not materialize, but they have ramped up worries. How would GM fare in a U.S. auto slump?
Lache: GM generated a little over $4 billion of free cash flow last year. A typical 20% North American auto downturn could reduce its North American profits by about 60%, or $6 billion, so the company would be burning cash if it did nothing. However, it has identified close to $10 billion of free-cash-flow improvements over the next two years, including about $4.5 billion of savings on fixed costs and about $1.5 billion of capital-expenditure cuts. That alone could offset a downturn. But GM also expects to get about $1.5 billion of annual dividends over the next few years from its finance company, $1 billion of earnings improvement from a new low-cost emerging market vehicle platform, and $1 billion in earnings upside from its new Chevy and GMC pickups.
Altogether, that’s $9.5 billion. So free cash flow would be near $4 billion in a downturn—close to what they had last year. GM’s story is extraordinary because of the value it has in Cruise and its free-cash-flow power. The $1.52 annual dividend is secure.
Q: Will the company spin off Cruise?
Lache: Investors won’t ascribe value to Cruise unless there’s a path for them to receive that value, so a spinoff must be part of the plan. Cruise needs to attract talent, and that talent wants to be compensated directly for what the business’ value will be. Some of the things GM is talking about, such as getting into autonomous mobility and expanding this globally, will be capital-intensive. It would be illogical for GM to try to raise additional capital with its own stock, which trades at a low multiple. That would be a huge disadvantage versus Waymo, Uber, or Lyft, which ultimately will have much higher valuations.
Q: What other companies do you like?
Dan Galves: BorgWarner (BWA) and Lear (LEA) are on our list.
Electrification, hybridization, and driver-assist systems offer big opportunities for suppliers. Products for hybrid drivetrains, like gearboxes, electric motors, and power electronics, can be a $50 billion market by 2023, up from about $8 billion in 2017. Driver-assist systems and highway autopilot-type systems can be $40 billion by 2025, versus $6 billion in 2017. BorgWarner makes a lot of components, like gearboxes and clutch packs, that are relevant for hybrids.
Lache: Their content per vehicle in combustion-engine cars is about $600. But they can generate $1,500 on hybrids and almost $2,000 on electrics. Remarkably, right now, hybrids are 70% of their net new-business backlog.
Q: What about Lear?
Lache: Lear has two businesses: seating and what they call E-Systems. Roughly two-thirds of their earnings comes from seating. They’ve been gaining market share and adding content there. E-Systems produces vehicles’ electronic and electrical architecture, and you’ll see huge changes as cars become electrified and move to higher-voltage systems. Typically, on an internal-combustion vehicle, Lear generates around $800 of content. For a hybrid, it could be $1,700; for a plug-in hybrid or fully electric vehicle, $2,500.
Q: You’re quite bullish on Aptiv (APTV), another supplier, too.
Galves: Yes. Aptiv grew its top line 9% in 2018 in a pretty flat global auto market. It provides wiring and connectors. As vehicles get more features, more electronics, and more sensors for driver-assist systems, they need more wiring and connectors. Aptiv also has a sexier business in driver-assist systems, like automatic braking. They produce radar, and are really good at integrating vision systems with the radar and computer architectures needed to monitor the driving environment. They have about a 15% market share in safety systems that look for dangerous situations and then steer or brake a vehicle autonomously.
What’s really exciting is the next step—when the vehicle, in a fairly stable environment like a highway, can steer, brake, and accelerate for the driver, using what’s called a Level 2+ system. A basic driver-assist system might cost an auto maker about $200; Level 2+ systems are more like $800 or $900. Aptiv is winning Level 2+ business at something like an 80% rate because of its expertise in integrating lots of systems. It had $14.5 billion in revenue in 2018. In 2015, 2016, and 2017, it booked about $19 billion a year of future business; in 2018, $22 billion. The stock trades at just 14 times expected 2019 earnings, even though Aptiv probably will grow its top line by double digits, with steady margin expansion.
Q: Tesla has been even more controversial than usual lately, with Elon Musk tussling with the Securities and Exchange Commission and the company first saying it would cut prices and sell only online, then that it will keep some stores and raise prices.
Lache: We’re still bullish. Despite all of the skepticism, this company has done what it said it would do: Sell small volumes of high-priced electric vehicles, like the Model S and Model X, to help fund development and production of mass-market vehicles, like the Model 3 and, eventually, the Model Y. The second half of 2018 was the first time that they had decent Model 3 production. They generated over $1 billion of earnings before interest, taxes, depreciation, and amortization in both the third and fourth quarters. We think that’s sustainable and enough to self-fund about 30% capacity growth for the next five years. From what we see in Europe and the U.S., it looks like demand will hold up.
Then there’s China, where Tesla gets only about 6% of its revenue. Some luxury auto makers get about 30% to 40% there. Tesla’s China factory is supposed to open in late 2019. Once they get local production and access to China’s EV subsidies, and eliminate tariff and shipping costs, their Chinese revenue percentage should go way up by late 2019, early 2020. That should be a big catalyst for the stock.
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