Auto Sector Grapples With Safety Recalls, Softening U.S. Sales

Strong sales in all major markets have been a boon for the auto sector lately. However, there are certain challenges like high expenses related to auto recalls. The rate of sales growth in the U.S. and Europe is also on the decline.

While there are several positives such as low gas prices, record U.S. sales and impressive China sales, there are also a number of factors that raise caution in the short and the long term. Below, we discuss some of the key challenges that the auto sector might face in the coming months.

Safety Recall Expenses

Safety recalls and related costs have turned out to be a major issue for most automakers. Per the U.S. Transportation Department, automakers recalled 53.2 million vehicles in the U.S. in 2016, setting a new record. In total, automakers announced nearly 927 recalls for safety issues in 2016, which is another record high.

The previous record for both the number of recalls and vehicles recalled was set in 2015, when automakers announced 900 recalls covering 51.1 million vehicles. Notably, these figures only cover the recalls in the U.S. -- the global numbers are much higher.

Auto recall figures for 2017 are also expected to be high due to the defective Takata airbag inflators, which resulted in significant recalls between 2014 and 2016. The U.S. regulators expect recalls to eventually affect roughly 42 million vehicles in the country, with nearly 70 million Takata air bag inflators. This also marks the largest auto recall in the U.S.

Meanwhile, Volkswagen (DE:VOWG_p) AG’s (VLKAY) emission scandal is responsible for a significant number of recalls. However, these are not included in the figures issued by the NHTSA as emission-related problems fall under standard violation and not safety. Recently, the EPA accused Fiat Chrysler (FCAU) of using software to manipulate emissions in vehicles that would have otherwise violated the Clean Air Act. This may again lead to a large number of recalls.

Strict regulatory implementation by the government and high fines imposed in recent years on many automakers for delay in reporting safety issues prompted many companies to proactively announce safety recalls. Recall-related repair costs increase the financial burden of auto manufacturers. A massive recall can also hurt sales as consumers start questioning the brand’s safety.

U.S.Sales Set to Plateau

Following two years of record volumes, most analysts believe that U.S. auto sales are likely to hit a plateau. Sales are expected to be significantly high this year but lower than 2016.

Pent-up demand from the Great Recession, which drove sales in the last few years, seems to have been satisfied. Moreover, with several rate hikes planned by the Fed, interest rate on auto loans may rise. This will have a direct impact on sales volume. U.S. auto sales in the first quarter of 2017 were the lowest first-quarter sales since 2009.

Risk of Border Tax

President Trump is planning to impose taxes as high as 35% on import of Mexico-made vehicles. While the policy is aimed at encouraging production in the U.S., most automakers have been producing a significant proportion of their vehicles in Mexico to advantage from lower costs for long. This allows them to reduce the cost of production, which ensures profitability of low-margin vehicle segments. A hefty border tax may force these automakers to reduce or completely stop production in Mexico, which can affect their bottom lines.

Slower Sales Growth in Europe

Although the European auto market is recovering, it is expected to witness slower growth this year. Per the European Automobile Manufacturer’s Association, car sales growth in 2017 is expected to slow down to 1%, compared to 6.8% growth witnessed in 2016. Uncertainty related to macro-economic conditions and political developments remain in the region.

Declining Used Car Prices

Used car prices have been declining in the U.S. The NADA Used Car Guide’s used car index has been falling consistently over the last few months, with an exception in March. In 2017, prices are expected to decline 6% year over year.

This has been supported by a large number of leased cars coming off of the lease, increasing the supply of used cars. A fall in the price of used cars will lead to a decline in the demand for new cars. Moreover, automakers may need to offer further incentives to boost new car sales.

Alternately, for companies such as CarMax Inc. (NYSE:KMX), dealing primarily in used cars, decline in the average selling price is expected to affect revenues.

Rising Delinquency Rates

Auto loans have been rising consistently over the last few years, touching a record $1.16 trillion in 2016, per the Federal Reserve Bank of New York. While this rise in loans has been driving auto sales, consumers with the riskiest credit profiles saw the highest growth. This has led to a significant rise in auto loan delinquencies. For loan providers, as bad debts increase, the loans provided will also decline, affecting demand for vehicles.

Market Share Concentration

The majority share of the automobile market is held only by a few leading automakers. This makes the automobile sector highly competitive. The top 10 global automakers account for nearly 81% of total vehicles sold, according to marketrealist.com.

Moreover, high dependence on these automakers makes auto parts’ suppliers vulnerable to pricing pressure and production cut. 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 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: https://www.zacks.com/stocks/industry-rank/auto-truck-orig-10

Bottom Line

The auto industry continues to face a number of challenges. As a result, we would advise investors to dump stocks with a Zacks Rank #5 (Strong Sell) such as Autoliv, Inc. (ALV), Mazda Motor Corp. (MZDAY) and Aisin Seiki Co. Ltd. Unsponsored ADR (ASEKY).

Meanwhile, investors who continue to be optimistic about the sector can check out companies like Cummins Inc (NYSE:CMI). (CMI), Fox Factory Holding Corp (FOXF) and GKN (LON:GKN) plc (GKNLY).

Cummins has an expected long term earnings per share growth rate of 9.8%. It recorded average earnings beat of 14.5% over the last four quarters. Cummins carries a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Fox Factory sports a Zacks Rank #1. The company has an expected earnings growth rate of around 16.6% for the long term. Fox Factory has a positive average surprise of 13.8% for the last four quarters.

GKN has a Zacks Rank #2 (Buy) and a long-term growth rate of 6.3%.

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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