Morningstar - Q2 2020 - 82

Investors

Moats, Motors, and Markets
The forecast may be cloudy, but a longterm view reveals opportunities.

S E C TO R R A P

Laura Lallos

Moats, or long-term competitive advantages,
are the hallmark of a high-quality company-
and some of the highest-profile automakers, such
as General Motors GM and Ford F, don't have
a bulwark against competition. But that doesn't
mean the entire automotive industry is
low quality.
In a recent Automotive Observer,1 Morningstar's
equity analysts point to actionable ideas
in the sector. Even without a moat, GM is a
turnaround story at a bargain-it has
earned a place on their Best Ideas list alongside
narrow-moat BMW BMW. Meanwhile,
industry suppliers such as Adient ADNT
and BorgWarner BWA often do have moats
and may provide opportunities for longterm investors.
I interviewed Automotive Observer coauthors Richard Hilgert and David Whiston
in February, and they updated their
comments in early April as markets plunged
and economic forecasts grew increasingly
uncertain. Their focus remains on the
long term.
Laura Lallos: Many automakers, like GM
and Ford, don't have moats to protect
them against competitors. But you do assign
BMW a narrow moat rating. What drives
moats in this industry?

David Whiston, CFA, CPA, CFE,
equity strategist with Morningstar
Research Services.

Whiston: In a nutshell, it's a very
capital-intensive industry, and the switching costs
for a consumer are virtually zilch. When you
want to get rid of your Camry, there's nothing
forcing you to buy another Toyota TM. Throw in the
cyclical factors of overcapacity issues and the
massive capital intensity required, and now a shift
to electrification that's requiring billions
of dollars in incremental investment, and it's very
hard to stand out.
Richard Hilgert, senior equity
analyst with Morningstar
Research Services.

Hilgert: Automakers have very little price leverage
with consumers when it comes to the mass
market. But when it comes to premium-and,
of course, exotic, like Ferrari RACE-there's lots of
price leverage. BMW does not have a massmarket brand or a commercial vehicle operation.
They are purely premium brands: BMW,
Rolls-Royce, and Mini. And BMW is well known for
engineering at a very high level that delights
the customer base.
Lallos: Yet BMW, along with the rest of the automotive
sector, has been undervalued for a while.

Hilgert: That's because the industry is facing
a high degree of disruption, and investors
are uncertain whether the industry will come

through this with its profitability intact.
Electrification is the primary disruptor right now;
we're switching over from the internal
combustion engine to battery electric. There's
also autonomous technologies. Fully autonomous
vehicles are a long way off, but some of
the precursors, like lane keeping and advanced
automated emergency braking, are making
their way into more new cars. These are expensive
to implement, and there's been some margin
degradation in some of these companies because
of the added cost. Then, there are Uber UBER
and Lyft LYFT and what they represent to auto
manufacturers' traditional business.
In my opinion, BMW and other automakers
will eventually adapt to these new market
opportunities. Electrification at some point will
represent a lower-cost proposition than
internal combustion engines, though it will take
some time. And over time, consumers will
warm up to battery electrics.
Whiston: The other overhang has been fear
of recession, with the worry now that coronavirus
panic-selling will push the U.S. into recession.
Hilgert: On top of that is valuation methodology
and what happened with light-vehicle production in 2019. Automakers and suppliers were
taking their guidance down in 2019. Nobody
lost money, with the exception of those that might
have had special charges that they took
during the quarter, so profitability was still there
for the industry. But our competitors look
at the industry with a methodology based on
a multiple to the current year's estimated
EBITDA. If guidance goes down, you've got to
take your price target down.

Our fair value estimates are long term-two and
a half to three years-so what's more important to
us is what we think a normalized, sustainable,
midcycle profitability is going to look like in
the final year. If the first year of a five-year explicit
forecast goes down but the midcycle stays
the same, that has a limited effect on my fair value
estimate; it might just be the time value of money

1 Hilgert, R., Whiston, D., & Su, I. 2020. "Moats, Motors, and Markets 2020: Global Autos Overview, Forecast, and Actionable Ideas." Morningstar Automotive Observer, January.

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