Tuesday, August 4, 2009

Auto Inventories Can't Drop Forever

Like the housing industry, the auto industry is currently in the midst of a cyclical downturn. In a cyclical downturn, a drop in demand (caused by a drop in consumer confidence, for example) leads to bloated inventories, which results in output cuts (plant closures, job losses etc.) as auto manufacturers try to reduce inventories. These output cuts then affect the revenues of all auto parts manufacturers. By tracking auto inventories, we can get a feel for how much longer these depressed revenue levels at auto parts manufacturers will persist.

The following graph depicts auto inventory levels alongside seasonally adjusted annualized auto sales in the US since 1993:

When demand is abnormally higher (or lower) than expected, inventories become depleted (or bloated) as a result. Auto manufacturers adjust output, bringing inventory levels back in line. Clearly, a major adjustment took place in late 2008 and early 2009. Sales seemingly fell off a cliff. As a result, the country was left with a pile of inventory. As retail sales stabilized, however, manufacturers cut output so drastically that even though retail sales remained low, inventories nevertheless fell quickly!

But inventories cannot fall forever. Auto makers will soon have to increase production such that inventory levels stop free falling. When they do, auto parts manufacturers will see their revenues rise. They won't rise to 2007 levels until retail sales show signs of returning to those levels, but they will not stay at their 2009H1 levels either, barring another shock to consumer confidence that causes retail sales to drop even further.

During this process, companies with fixed costs (e.g. debt/pensions/leases) that cannot be met will go bankrupt. Value investors are looking for the companies with the staying power (i.e. the cost structures and low debt levels) that will allow them to pick up this dropped market share and thus benefit disproportionately when output stabilizes.

Source: BEA

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