The slowdown in US auto sales, heavy use of financing deals by car buyers and the leverage assumed through a recent acquisition have driven us towards a defensive position against auto-parts specialist American Axle.
The US automotive sector has shifted up through the gears since the 2008 financial crisis. Seasonally adjusted annual sales (SAAR) of new cars and light trucks reached a peak of 17.6m in 2016, higher than the 16.2m recorded in 2007 and 10.4m as the crisis unfolded in 2009 .
By interrogating the data, we find that light trucks – including pick-up trucks, sports utility vehicles and crossovers – have led the ongoing recovery since 2015 as passenger-car sales began to decline (see figure 1). This demand was driven by factors including evolving consumer preferences, lower oil prices and manufacturers’ aggressive use of discount incentives.
Macroeconomic conditions also helped fuel the recovery, enabling automakers to offer financing to potential buyers at low interest rates and with longer terms. Immediately after the crisis, the proportion of vehicles bought through finance was in the mid-70% range but today it stands at 85% .
Figure 1. The US auto sector’s recovery has been driven by light-truck sales
Source: Bloomberg as at February 2018
Sales sputtering out
But vehicle sales in the US are slowing. Volumes may have exceeded 17m again in 2017 and in early 2018, but growth has decelerated: passenger-car sales growth has experienced a double-digit fall and truck sales are also slowing as demand for replacements following the hurricanes of late 2017 weakens.
There are further obstacles. The popularity of vehicle leasing in recent years will lead to a glut of used cars on the US market as leases end in 2018 and 2019. This additional supply will depress values in the used-car market, and that in turn means that the monthly cost of taking out a lease will have to rise to compensate for higher expected depreciation, slowing new-car demand.
Another worry is credit terms, which have started to worsen and could deteriorate further if US interest rates continue to rise, which could stall purchases of new cars. At the same time, the aggressive discount incentives provided by automakers have gone so far that it is now difficult to increase them further (see figure 2).
Figure 2. Monthly incentives from US automakers have risen consistently
Source: Autodata, JP Morgan as at February 2018.
Heavily exposed: American Axle
Auto-components supplier American Axle & Manufacturing Inc. (AXL) generates 80.2% of its sales from North America, and focuses on supplying parts for light trucks and SUVs. Its primary business is to provide auto manufacturers with drivelines, metal forming, powertrain and casting products – more traditional components that are less affected by auto-market megatrends, such as the shift to hybrid or electric power sources.
AXL’s business profile has improved following its transformative acquisition of Metaldyne Performance Group Inc. (MPG), another auto-components supplier, in 2017. As a spin-off from General Motors Company (GM), AXL’s customer diversification was, until recently, weak and deeply reliant on the major US car maker. But the acquisition of MPG, which cost $1.6bn in cash and stock and $1.7bn in net debt, remedied this problem. The business’s sales to GM decreased to 47% in 2017 from 67% in 2016. AXL should also be able to extract some synergies from the buyout, allowing its profit margins to increase.
However, the absorption of MPG’s debts also affected AXL’s credit metrics. The business’s net leverage increased significantly to 3.5x on a pro forma basis as US auto sales peaked (see figure 3). However, AXL’s management team has been able to reduce the company’s leverage to its target of less than 3x, on a pro forma EBITDA-adjusted basis, since the buyout.
Figure 3. AXL: quarterly performance and leverage
Source: AXL as at December 2017
Auto majors are well positioned
Major automakers, such as GM and Ford, have worked hard to reduce their cost bases in order to be able to reach break-even if monthly US auto sales fall towards the 10-11m range. Both businesses have geographically diversified operations, with GM selling 76.5% in North America and Ford selling just 59.6% there, according to the companies. They benefit from strong balance sheets, with GM enjoying margins of 10.7% and Ford 8% in North America.
The businesses have net cash positions in their industrial arms and good cash-flow generation, with GM reporting free operating cash flow of $5.5bn and Ford $2.5bn for the 2017 financial year. GM is investing heavily in the latest auto-sector megatrends, enabling it to be well placed to meet demand for new products, particularly electric vehicles (EVs). The firm has allocated capital expenditure of $8.4bn to EVs, while Ford is investing $7bn.
Compared to these large auto manufacturers, AXL is clearly more exposed to a slowdown in US new-car sales and has the additional disadvantage of a weaker balance sheet.
AXL: defensive positioning
AXL’s credit default swap (CDS), a type of security that insures investors against the company defaulting on its debts, has performed quite well since the MPG acquisition was announced in late 2016. This is thanks to relative resilience in US new-car sales so far, as well as hopes the business will extract synergies from the MPG buyout and reduce its reliance on GM.
However, we feel that market conditions could deteriorate quickly in the automotive industry and AXL will not be well placed to face up to this challenge.
The company has a weak balance sheet with high net leverage for an auto-parts supplier. For these businesses, we consider a net leverage ratio of more than 2x to be already extremely high, and companies in such a position are usually rated as medium-quality high-yied debt. To achieve a higher rating, auto-parts suppliers generally need to have a net leverage multiple of 1x or lower.
Furthermore, decelerating light-truck sales could have a bearing on the company’s ability to reduce the amount of debt on its balance sheet, and therefore decrease its leverage. In light of the fact that the management team has cut leverage to meet its end-of-2017 target, we cannot rule out another acquisition. If AXL sought more M&A, a further increase in the business’s leverage in the current environment would put the company at risk, in our view.
For these reasons, we have invested in AXL CDS as a defensive trade.
Figure 4. Evolution of AXL’s CDS
Source: Bloomberg as at 13 March 2018