Morningside: Hot Cars Won't Drive Profits

Nots From The Detroit Auto Show by Pat Dorsey, Director of Stock Analysis

Detroit and its foreign counterparts are turning out some of the most creative new designs in years, but whether this will benefit the automakers' share prices is still an open question.

The Cars

Anyone at the Detroit auto show could spot what was hot: crossovers and retro styling.

Crossovers are a pretty fuzzy group. Some look like the offspring of a car and an SUV (such as Chrysler's Pacifica), others are more of an SUV/pickup truck combination (Ford's Explorer SportTrac), while still others like the Chevy SSR make the full jump from car to truck.

Retro styling, like the crossover wave, is just getting under way. It's already out there in the new Ford Thunderbird, hearkening back to the industry's golden days of the 1950s. In fact, the NAIAS ``Best of Show'' award went to GM's Pontiac Solstice.

So no car better symbolizes the future of auto styling than Chrysler's retro-crossover PT Cruiser. Even Chrysler itself was shocked by the unexpected demand for this 1930s gangster-car throwback, which captured 144,000 buyers in 2001 at prices (and profits) far beyond what the automaker expected. Its unusual style is sure to garner strong reactions--you'll either love it or reject it out of hand.

Like any trend that meets unexpected success, the PT Cruiser's success is just the tip of the iceberg. The global auto industry is sagging under the weight of excess capacity, and most automakers can't compete on cost alone. But as cars and trucks mutate into each other, and past and future styling cross paths like never before, buyers can select from far more permutations of form and function than just a few years ago. And a customer who finds the ``perfect'' car or truck is more likely to pay a premium price. The story is an old one: Differentiate your product, and you can charge more. You have to wonder why it took Detroit so long to figure this out.

But niche models that inspire devotion from some and revulsion from others run counter to Detroit's traditional mass-production model, so these revolutionary designs won't necessarily lead to outsized profits. It takes a good 200,000 or 250,000 vehicles per year to fill a standard assembly plant efficiently, but most of these new vehicles don't stand to even approach those numbers. For now, GM and Chrysler appear to be taking the lead, but whether or not they'll succeed with this strategy is still an open question.

There's also the risk that too many crossovers and retro cars (as SUVs before them) will crowd their respective markets, leaving profits dependent on low-cost production. That's never been Detroit's strong suit.

The Companies

Although the cars were exciting, the tone off the floor was a bit more subdued. After all, the industry just finished the second-best year in the history of auto sales, but the Big Three (General Motors GM, Ford F, and DaimlerChrysler DCX) collectively lost billions of dollars. Some analysts, such as Gary Lapidus of Goldman, have christened this phenomenon ``profitless prosperity.''

Of the Big Three automakers, only GM exuded much enthusiasm. Despite the gush of red ink in Dearborn and in Auburn Hills (Chrysler headquarters), GM was profitable in 2001--even in its oft-maligned North American business. That, plus the shares' 4% dividend, makes GM by far the best of a bad lot.

Ford, on the other hand, used Friday's presentation to announce an anxiously awaited restructuring. Even after closing five plants and shedding 34,000 jobs, CEO Bill Ford Jr. says it will still take years to revive profits back to 2000 levels. After its astounding comebacks in the early 1980s and again in the early 1990s, I wouldn't ever count Ford out--but the current share price still leaves me cold.

Time to Buy?

If anything, ``profitless prosperity'' might be a best-case scenario for 2002--it isn't as though industry conditions can't get worse. Virtually every company made dismal pronouncements on the future of auto sales, with some expecting unit declines of 15% or more this year.

Yet opportunities still exist, particularly in the North American supply base. Companies like Johnson Controls JCI and Gentex GNTX have put up great long-term returns for investors by avoiding (if not taking outright advantage) of Detroit's poor economic circumstances. JCI, which has outperformed the S&P 500 more than twice over in the past decade, is a stock we'd definitely watch for buying opportunities.

And as moribund as the automakers themselves look right now, this isn't a time for investors to write them off completely. The biggest profits in this industry always start with a gutsy buy when conditions look the worst. I have no doubt that a time is coming--though probably later as opposed to sooner--that Ford and GM will be great buys.

Just not yet.