Daniel Downey for Barron's

While the car of the future gets ecstatic previews, the auto industry of the present elicits pity and scorn.

Electric cars are widely expected to supplant vehicles powered by the internal-combustion engine, leaving traditional auto makers and their gasoline- and diesel-powered clunkers in a heap of rust.
This dismissive view is especially prevalent on Wall Street, where shares of the leading auto manufacturers trade for a mere six to 11 times 2017 expected earnings, and sport dividend yields as high as 5%. Yet, even as electric cars, autonomous vehicles, and car sharing disrupt the status quo, the global auto industry could prove resilient, and reward customers and shareholders in myriad ways.
Major auto makers are all working on new technologies and initiatives, while reorganizing existing operations in value-enhancing ways. Accordingly, fans argue that the stocks are much too cheap. Auto shares rarely command high price/earnings multiples, but today’s valuations are low historically in both absolute terms and relative to the Standard & Poor’s 500 index, which is trading around 20 times this year’s projected operating profits. (Upstart Tesla [TSLA], meanwhile, is looking overvalued.) With global auto sales climbing and earnings poised to rise or at least hold near current levels, the stocks could head higher in the next year or so.
“There is no company without issues, but the risk/reward is favorable,” says David Herro, manager of the market-beating Oakmark International fund. “We know the risk of autonomous cars in the next five to 15 years, but the stocks trade for extremely low valuations. The auto markets and earnings are healthy. Balance sheets are strong.” Three of the top 10 holdings in Herro’s fund are auto makers: BMW (ticker: BMW.Germany), Toyota Motor (TM), and Daimler (DAI.Germany), the maker of Mercedes cars.
PRESSURED BY INVESTORS and the success of Tesla in electric vehicles, auto manufacturers are getting more shareholder friendly, and spending heavily to counter the upstart. “Elon Musk [co-founder and CEO of Tesla] has been more effective than any activist investor in getting auto makers to run their businesses more efficiently, more effectively, and in a more forward-looking manner,” says Nicholas Colas, co-founder of Datatrek, a financial newsletter, and a longtime follower of the auto industry.
General Motors (GM), the largest U.S. auto maker, exited its money-losing European operations last year and is expected to return $7 billion to holders this year in dividends and stock buybacks, equal to about 10% of its market value. GM has made autonomous, or driverless, vehicles a major focus, and is thought to be No. 2 globally behind Alphabet’s (GOOGL) Waymo division. Daimler and Volkswagen (VOW3.Germany) are considering spinoffs of their valuable truck divisions, while spending heavily on electric vehicles, with VW planning to shell out $84 billion by 2030.
Few industries outside technology are sitting on as much cash as the auto makers. BMW’s automotive net cash and investments total nearly 19 billion euros ($22 billion), or one-third of the company’s market value. Daimler has more than €20 billion of net cash, or cash minus debt, and Toyota has $70 billion, 35% of its market capitalization. Risk-averse auto makers have been unwilling to part with their cash, in part because they view it as support for their large finance units. But that attitude could start to change.
Auto stocks have begun to rally in recent months, and could have considerable upside. GM shares have gained 20% since August, to $42, but still trade for under seven times projected 2017 earnings. VW, the subject of a bullish Barron’s story in August, has risen 23% since then, to €157, yet trades for only six times estimated 2018 earnings.
Some industry experts have put forth unusually bullish projections for electric vehicles.

Morgan Stanley analysts have written that electric cars could reach 80% to 90% of global sales by 2050, up from about 1% now, as battery costs decline and regulators worldwide push to eliminate gasoline- and diesel-powered vehicles. By 2040, the firm estimates, electric vehicles could total nearly 30% of the global fleet, compared with 0.2% this year.
Yet others think projections of electric-vehicle growth will prove too high. “The demand estimates for electric vehicles could prove to be wildly optimistic, tempered by the impracticalities of lengthy charging times and limited range,” says Kenneth Garschina, a founder of Mason Capital Management, a New York investment firm.
Even if electric cars take off in the early to mid-2020s when their cost is likely to be comparable to gas- and diesel-powered vehicles, Garschina thinks the major global auto makers will still dominate the business. Credit Suisse auto analyst Daniel Schwarz recently wrote that auto makers would emerge as winners from simpler, less capital-intensive production of electric vehicles over the next 10 years.
Investors might not be giving the auto industry credit for manufacturing skills honed over decades. As Tesla has found, mass-producing automobiles isn’t easy; the company continues to lose money and grapple with production woes. “The more we learn about new technologies, the clearer it becomes that the key auto makers won’t be disrupted overnight,” says Arndt Ellinghorst, a European auto analyst with Evercore ISI.
MORGAN STANLEY HAS estimated that it could take $2.7 trillion of infrastructure investment by 2040 to support a global electric fleet, including 473 million home chargers and seven million super-charging stations. It’s unclear where all that money will come from. The additional need for electricity would be equivalent to current U.S. demand.
And it remains to be seen if autonomous cars and ride-sharing programs gain much acceptance, even in densely populated urban areas. Part of the bear case for auto stocks is that a surge in ride sharing in the 2020s will cut into demand. “Ride sharing is a huge logistical challenge,” Colas says.
Ellinghorst complains that the auto industry isn’t getting credit for its strong financial performance in the past decade, with revenue up 36% and cash flow, as measured by earnings before interest, taxes, depreciation, and amortization, or Ebitda, more than doubling. “What drives us mad is the fact that in a world of massively inflated asset prices, auto companies have derated like no other group of listed equities,” the analyst wrote in a client note last month.

There are plenty of risks in the sector. GM and Ford Motor (F) are dependent on the U.S. for the bulk of their earnings, and most profit comes from pickup trucks and sport-utility vehicles. Investors worry that domestic sales and earnings are peaking. The industry will have to absorb the costs of building electric-vehicle capacity and technology while maintaining the manufacturing infrastructure around internal-combustion engines. Still, the bad news looks to be in the stocks.
Here is a look at six global auto makers.
Wall Street is starting to give GM credit for its sharply rising profits and restructuring efforts, including the sale of its European operations. Investors also applaud the company’s ambitious cost-cutting program, electric-vehicle initiatives with Chevy Bolt, and investments in autonomous-vehicle technology.
Third-quarter results of $1.32 a share were better than expected and highlighted GM’s progress in controlling costs. The stock’s 21% gain this year reflects GM’s improved financial results, and more important, the impression that GM is ahead of rivals in developing autonomous vehicles.
“Investors not only worry about cyclical pressures in autos, but that once we get into the next cycle, Tesla will dominate electric cars, and Waymo, Uber, and Tesla will dominate autonomous,” says Brian Johnson, an auto analyst at Barclays. “GM is showing it can play in electrics and autonomous.”
GM is expected to earn $6.32 a share this year, and $5.86 in 2018. Next year’s net will be depressed by factory downtime related to a model changeover for full-size pickups.
GM accelerated its autonomous-driving project with the purchase of Cruise Automation for a reported $1 billion in 2016, and now is testing a fleet of cars in San Francisco. CEO Mary Barra said on GM’s third-quarter earnings conference call that it will be “quarters, not years” before GM can take out the driver. Cars now have a driver as a backup.
Johnson believes GM could launch a ride-sharing autonomous business in the early 2020s. In the meantime, investors could enjoy generous capital returns, including a 3.6% dividend yield and stock buybacks equal to more than 5% of GM’s market value.
Ford shares are little changed this year at a recent $12. Wall Street fears that Ford lags GM in electric cars and autonomy, with Ford targeting 2021 for commercial production of its first driverless vehicles.
The shares trade for less than seven times projected 2017 earnings of $1.82 a share and yield 5%.

Unlike GM, Ford repurchases little of its own stock. “Momentum and investor sentiment is superior on GM but Ford is attractive from a deep-value perspective,” says Ryan Brinkman, an analyst at JPMorgan. He has an Overweight rating on the stock, and a $15 price target.
Ford has almost $10 billion of net cash in its automotive unit but, like GM, has underfunded pension and health-care obligations. Ford’s obligations total about $14 billion.
Third-quarter profit of 43 cents a share topped consensus estimates by about a dime, helped by strong results in North America, where the company’s full-size F-150 pickup truck and sport-utility vehicles—the Ford Expedition and Lincoln Navigator—powered results. Full-year earnings are expected to be hurt by a $600 million headwind for foreign exchange in Europe, which accounts for 20% of company sales, and $700 million in recall expenses. Wall Street sees Ford earnings falling in 2018 to $1.57 a share on weakening sales, prices, and profit margins in the U.S. market.
Ford’s truck business could be worth $20 a share, according to Morgan Stanley analyst Adam Jonas.

But the unit is attached to a U.S. car business that’s believed to lose money, and non-U.S. operations that run near break-even. Jonas has argued that Ford ought to consider a major restructuring, including the sale of its European and South American operations and a stake in its Chinese joint venture, and even an exit from much of its small and midsize car business globally.
Investors generally welcomed Ford’s decision to name Jim Hackett as CEO in May (replacing Mark Fields), given Hackett’s experience in ride sharing and his commitment to new technologies, including electric cars. Ford plans to introduce 13 electric vehicles in the next five years, but most will be gasoline/electric hybrids rather than fully electric models.
The German auto maker’s liquid nonvoting shares are up 18% on the year, to €157, as investors look past VW’s “dieselgate” scandal that might cost $30 billion. Even so, the stock trades for only six times projected 2018 profits of €25.51 a share. VW’s U.S.-listed shares (VLKAY) fetch around $37 and are worth a fifth of the Germany-listed shares. “Where else can you find a company trading for five times earnings with great brands, huge asset value, and growing profits?” asks Garschina of Mason Capital, who has an above-consensus 2018 earnings estimate of €30.
VW is the world’s largest auto maker, with $269 billion in annual revenue and a portfolio that includes luxury brands Porsche and Audi and the mass-market VW line. Garschina puts the company’s asset value at €350 per share. Barron’s has noted that Porsche alone could be worth nearly half the company’s current market value of €80 billion. Plus, VW has €25.4 billion of net cash and investments.
Volkswagen’s earnings could rise nicely in coming years with improvement in the VW brand helped by new SUVs. Evercore ISI’s Ellinghorst thinks VW should separate its valuable truck businesses, Scania and MAN, because truck companies get twice the valuation of auto producers and the two businesses have little in common. The global truck business benefits from an oligopolistic structure. Scania has the second-highest margins behind Paccar in the truck market.
VW is making a major push into electric cars and aims to sell two to three million by 2025. It is also a leader in autonomous driving. This year the Audi A8 became the first car to offer “level 3” autonomy that allows for hands-free driving under certain highway conditions.
An even cheaper way to play VW is through Porsche Automobil Holding (PAH3.Germany), which owns just over half of VW’s voting shares. Porsche shares, now around €62, trade at a 30% discount to VW, but carry some legal liability stemming from Porsche’s purchase of VW stock a decade ago. Porsche so far has won in court and analysts see the company continuing to prevail.
The global leader in premium cars and heavy trucks, Daimler looks undervalued at €70. The U.S.-listed shares ( DDAIF ) trade near $83. Daimler’s U.S. shares are up 11% this year, as the company has taken preliminary steps to separate its truck business, which accounts for 20% of annual revenue of €153 billion. Given the complex oversight structure of German companies and the strong role of labor unions, such a move might not happen until 2019 or later. Daimler is expected to keep control of the unit.
Ellinghorst values Daimler at about €101 a share on a sum-of-the-parts basis. His analysis assumes that the Mercedes auto business is valued at a conservative three times Ebitda, around the same valuation as Ford’s. Ellinghorst has an Outperform rating on Daimler, and a price target of €85. “We remain convinced that Daimler and Volkswagen are too large and complex to be managed effectively at a time of unprecedented change in the auto industry,” he wrote in a client note.

Even a partial breakup could lead to a higher valuation.
Daimler trades for eight times projected 2017 earnings of €9 a share, a multiple that gives the company little credit for its truck business. Truck makers Volvo (VOLV-B.Sweden) and Paccar  (PCAR) trade for 17 times earnings. Daimler’s European-listed shares yield 4.6%.
Daimler says it plans to offer one electrified alternative in each of its models by 2022.
BMW is one of the world’s few pure-play makers of premium cars. The shares, listed solely in Germany, are down 2% this year, to €87, and trade for just eight times projected 2017 and ’18 earnings of around €11 a share, a valuation that gives the company little credit for consistently high operating profit margins of around 10%. “BMW has a recognizable global brand and a strong presence in emerging markets, and generates a lot of cash,” says Herro. “Both Daimler and BMW are significantly undervalued.”
A third of BMW’s market value of €57 billion is in cash and marketable securities at the company’s automotive unit. (This calculation excludes the finance business.) Herro notes that BMW’s enterprise value (market value less net cash) of $46 billion is lower than Tesla’s, at $59 billion. BMW will sell more than two million vehicles this year, including 100,000 electric cars (with hybrids), compared with Tesla’s expected production of 100,000 cars. Tesla could lose $1.5 billion in 2017.
Credit Suisse’s Schwarz argues that BMW’s earnings power is underappreciated. He cites the positive impact of several new models, including the 5 series sedan and X3 sport-utility vehicle. “It is the most profitable of European auto makers, with a product cycle that should accelerate from here,” he says.
Schwarz expects BMW to earn almost €14 a share in 2019, above the consensus forecast of €11. He rates the stock Outperform, with a price target of €126 a share. Shares yield 4%.
Japan’s Toyota is the world’s most profitable auto maker, and the largest by market value at $205 billion.
The U.S.-listed shares hit a 52-week high last week of $128.11, and traded Friday at $124. They sell for 11 times estimated earnings for the fiscal year ending next March, and yield over 3%. Japanese car makers historically have traded at a premium to U.S. and European peers due to higher returns and ultralow Japanese interest rates.
Toyota reported better-than-expected results this past week for the September quarter, and raised its forecast for full-year operating income to two trillion yen ($17.7 billion) from JPY1.85 trillion in a prior forecast. “Toyota has top-notch manufacturing and exposure to the premium sector with Lexus and emerging markets,” says Oakmark’s Herro.
The company has focused on hybrid cars such as Prius rather than pure electric vehicles.
Nomura analyst Masataka Kunugimoto recently upgraded Toyota to the firm’s top auto pick, citing the potential to “gain market share while minimizing discounts in key markets.” He says the company should emerge as the industry’s “next-generation technology leader” with investments in hybrids, solid-state batteries, and self-driving technologies. His price target is about $160 a share.
LASTLY, A WORD ABOUT Tesla, whose shares have fallen 20% from a September all-time high to a recent $304. The company posted a record quarterly loss of $619 million, or $3.70 a share, in the latest period, and said production of its mass-market Model 3 won’t hit 5,000 a week until the end of the first quarter of 2018, versus a prior estimate of the current quarter. Musk has said he has “zero concern” about hitting production of 10,000 a week at some point in 2018. But the company’s skeptics doubt that claim.
Based on competitors’ output, that’s not a lot of cars. But each Tesla that rolls off the production line arguably spurs the rest of the auto industry to innovate, adding value for all stakeholders, including investors.