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Detroit is Not the Auto Industry

By: Martin Tillier
Posted: 7/22/2013 12:15:00 PM
Referenced Stocks: CARZ;DLPH;GM;JCI

On Thursday, the city of Detroit filed for the largest municipal bankruptcy in history. This is a blow for debtors and bondholders and a potential tragedy for those owed pension and other benefits by the city. The extent of the misery can be gauged by how quickly the political finger pointing has begun. The very people responsible for the mess, i.e. politicians, are busy accusing each other. As one who studies the habits of successful companies, it seems to me that whether you give benefits or tax cuts to bribe your particular followers, leaving future generations to foot the bill for your profligacy is a greedy, short-sighted, tactic doomed to failure. Okay, I feel better now that I’ve got that out of the way.

The city of Detroit is, to most Americans, inextricably linked with the auto industry. It is, after all, the Motor City. The fact is, though, that General Motors (GM) is the only major manufacturer still located in the city. If the industry is taken as a whole, including the foreign manufacturers with plants here, for example, the industry is geographically diverse within the US. Detroit’s problems are tragic, but they tell us nothing about the auto industry. I stated here that rising oil prices could hit GM, whose recent sales growth has been dominated by less fuel efficient vehicles. As long as oil prices rise steadily, however, they are unlikely to de-rail the recovery in the sector in general.

If you want to take speculation about the oil market out of the equation, but still believe the recovery for the auto market is for real, you need to take the popularity of various manufacturers out of the calculation. The obvious way to do this is to buy an industry ETF, such as the First Trust NASDAQ Global Auto Index Fund (CARZ). The problem here is that you get the good lumped in with the bad, and with the top 10 holdings representing over 60% of the portfolio, the bad will drag down performance significantly. Returns will be average, and if average is good enough for you, then have at it!

If, however you are looking to beat the average, US parts suppliers can ride any sector growth, and as long as the manufacturer has a plant or plants here, it doesn’t matter who benefits most. Johnson Controls (JCI) and Delphi (DLPH) are two suppliers in very different situations, but each could benefit enormously from sustained growth in new car sales over the coming months and years.

Johnson Controls Inc. (JCI)

JCI is struggling to return to profitability. Their latest earning release, while still showing a $0.17 per share loss, beat expectations and was accompanied by an upbeat forecast, resulting in the stock jumping around 10%. The company grew rapidly in the early 2000s, and, working on the principle that big is beautiful, expanded away from their core seats and interiors business. Recent success has come as they try to shed some of their peripheral product lines, a move that many regard as overdue, but welcome. A leaner, more focused JCI will be in a great position to benefit from any growth in the new car business, and their “clean technology” products could offset any weakness should oil spike.

Delphi Automotive (DLPH)

Ironically, when JCI put its electrical components division up for sale as part of their re-focusing, DLPH was said to be interested. They have since backed away from any possible deal, which is probably wise. The industry seems to have learnt that, for now at least, concentrating on core business is a good idea. Delphi entered bankruptcy in 2005 with 44 plants in the US, and emerged, finally, in 2009, with 4. They have a messy and controversial history, but the re-organized company completed its turnaround with the 2011 IPO, since which the new stock has been almost a one-way bet, rising from the offering price of $22 to around $55.

They are currently showing earnings of $4.56 per share, giving a P/E of around 12, which makes some multiple expansion possible to go with any top line increase from an improving market, and pay a dividend around 1.25%.

The events in Detroit say a lot about the incompetence of politicians, but little about the success of the auto industry. If taken as a whole, I expect the industry to continue its remarkable recovery. Given the difficulties in picking a winning manufacturer, however, JCI and DLPH may be the best way to play that recovery.