Can the Auto Industry Ride Out Chinese Gloom, Massive Recalls?

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Falling sales in China and recall-related headwinds are two big challenges to the auto industry at present. Since automakers were banking on growth prospects in Asia, a downturn in China will have a major impact on global sales. Moreover, the massive volume of recalls due to the defective Takata airbag inflators, and now the Volkswagen AG ( VLKAY ) emission scandal, will significantly inflate automakers' expenses.

On the other hand, there are many positives such as low oil and gas prices, impressive domestic sales and a sustained recovery in Europe. Moreover, deeper focus on the safety of vehicles is benefiting parts manufacturers, specifically those dealing with automotive safety products.

Still, there are plenty of reasons to be careful about the auto industry stock space for both the short and the long terms. Below, we discuss some of the key challenges that investors in the auto sector should watch out for in the coming months and years:

Falling Sales in China

Many automakers, including the likes of Ford Motor Co. ( F ) and General Motors Company ( GM ), had been banking on strong sales growth in China to drive their earnings over the next few years. Although the nation recorded exceptionally strong auto sales in 2014, the growth rate started receding toward the end. This year, auto sales in China have been falling year-over-year every month since May. Consequently, the year-to-date auto sales have also fallen below sales seen in the first 8 months of 2014.

The sale of commercial vehicles plunged 12.6% in Jan-Aug 2015. Although strong demand for SUVs and MPVs drove up the sales of passenger cars by 2.6% during the period, it has been falling for the past 3 months.

Slowing economic growth in China is leading to the sluggishness in vehicle sales. As China is the largest automobile market in the world, a decline in vehicle sales or even a slowdown in the growth rate can significantly hurt the revenues of automakers.

Cost of Safety Recalls

Safety recalls and related costs have become a major issue for most automakers in recent years. An astounding 632 recalls covering 22 million cars were announced in 2013. In 2014, safety recalls were at record levels.

Automakers recalled over 60.5 million vehicles in the U.S. in 2014, according to the National Highway Traffic Safety Administration ("NHTSA"). This figure is nearly double of the last record of 30.8 million vehicles in 2004. Moreover, these figures only cover the recalls in the U.S. and the global recall numbers are much higher.

The high recall story was widespread in 2015 too. Defective Takata airbags, which resulted in significant recalls last year, can be blamed for the maximum recalls this year as well. Per an NHTSA official, around 19.2 million vehicles in the U.S. have faulty Takata airbag inflators. Of these, around 4 million vehicles have defective inflators on both the driver and passenger side airbags. Thus, the estimated number of flawed Takata airbag inflators in the U.S. is pegged at 23.4 million units.

Moreover, these are just figures for the U.S. The global recall count is much higher. Takata and 11 automakers, including Toyota Motor Corp. ( TM ), Nissan Motor Co. Ltd. ( NSANY ), Ford and Honda Motor Co., Ltd. ( HMC ), have been affected by the issue. The biggest victim, however, is Honda - Takata's largest customer.

Moreover, the volume of recalls this year is set to increase now that Volkswagen's diesel vehicles in the U.S. have been detected with a software algorithm which allowed it to deceive U.S. emissions tests. The software switches on pollution controls during emission tests but switches them off when the vehicle is on road. According to the EPA, the Volkswagen vehicles in question emit nitrogen oxides, or NOx, at almost 40 times the standard amount.

Consequently, Volkswagen has been forced to halt the sale of its popular diesel-powered vehicles in the U.S. Almost 11 million vehicles around the world are equipped with this software. Many other countries have also started investigating whether Volkswagen uses similar tactics to deceive their respective emission tests. The size and scope of the Volkswagen scandal is getting compared to the BP's ( BP ) oil-well disaster in the Gulf of Mexico a few years back.

The recall-related repair costs intensify the financial burden of auto manufacturers. A massive recall also hurts sales volume as consumers start questioning the brand's safety.

Market Share Concentration

A few leading automakers hold a majority of the market share, which makes the automobile sector highly competitive. The top 10 global automakers account for nearly 81% of the total vehicles sold, according to

Moreover, high dependence on these automakers makes auto parts suppliers vulnerable to pricing pressure and production cuts. Pricing pressure from automakers constricts margins of parts suppliers. Simultaneously, frequent production cuts by automakers to cope with market adjustments affect suppliers' operations.

Some auto industry suppliers that are highly dependent on a few major automakers are Meritor Inc. ( MTOR ), Tenneco Inc. ( TEN ) and Magna International Inc. ( MGA ). The full list can be seen in this auto supplier page .

Bottom Line

While the auto industry's near-to-medium term picture is fairly reassuring, a number of long-term challenges remain.

Check out our latest Auto Industry Outlook here for more on the current state of this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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VOLKSWAGEN-ADR (VLKAY): Free Stock Analysis Report

TOYOTA MOTOR CP (TM): Free Stock Analysis Report

TENNECO INC (TEN): Free Stock Analysis Report

NISSAN ADR (NSANY): Free Stock Analysis Report

MERITOR INC (MTOR): Free Stock Analysis Report

MAGNA INTL CL A (MGA): Free Stock Analysis Report

HONDA MOTOR (HMC): Free Stock Analysis Report

GENERAL MOTORS (GM): Free Stock Analysis Report

FORD MOTOR CO (F): Free Stock Analysis Report

BP PLC (BP): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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