Geography matters in the automotive industry
As we saw earlier in this series, General Motors (GM) and Ford (F) have leading market positions in trucks in the U.S. F and GM both rely on the U.S. truck market to support weaker margin compact cars in the U.S. and globally. For example, GM in fiscal year 2013 reported approximately two-thirds of its total revenue from the North American market, which in turn is over 90% U.S.-driven. Similarly, GM’s earnings are driven by the North American market, with 87% of 2013 earnings before interest and taxes (EBIT) from North American operations. EBIT margins were 8% in North America, negative in Europe, and 3% in GM’s international operations. The U.S. market is dominated by truck sales, with trucks outselling cars at 51% of market share versus cars accounting for 49% of the market. This explains why global manufacturers pursue the truck and SUV markets in the U.S.
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In light of the poor earnings of GM and F cited above, why would they pursue the European market so vigorously? They get engineering, design, and manufacturing operating leverage to their global operations. Let’s consider what they would give up if they were to close down tomorrow. They could sell or close down their European operations. In either case, they’d have to fund the pensions and pay the closure expenses for the facilities, which would run into the billions. Improving the performance of the European operations remains a high priority for both GM and F.
A geographical observation on Toyota is that it produces 40% of its vehicles in Japan. This compares to Japan comprising approximately 24% of TM’s annual sales. This production in Japan is lower than 40 years ago, when Japan began manufacturing in the U.S. to mitigate threatened tariffs against Japanese auto manufacturers. Global automotive manufacturers moved manufacturing globally to reduce costs, maneuver around tariffs, and better match their foreign exchange exposure. For example, the yen has ranged from 123 per $1.00 to 76 per $1.00 over the past seven years. Shifting manufacturing overseas allows manufacturers to match costs with revenues as well as present themselves as helping the local market manufacturing base. In this case the depreciating yen is helping TM.
The geographical footprint of automobile manufacturers mitigates exchange rate risk. The chart above shows the relationship of the U.S. dollar to the Japanese yen (USD/JPY) and the U.S. dollar to the euro (USD/EUR). The left axis is the USD/JPY relationship, showing the dollar has been worth JPY70 to JPY120 over the past seven years. Imagine planning five years out with a new model introduction. If you’re TM selling a vehicle manufactured in Japan in the U.S., your revenue would swing nearly 60%. When the yen is depreciating, your earnings would benefit, as your parts are purchased in JPY and selling in USD. In the medium term, this would affect prices, but in the short term, excluding hedging, TM would be expected to report significant earnings improvements. As the JPY depreciated from 82 to 94 JPY/USD, TM’s earnings improved by 150 billion yen.
The graph above shows the USD/EUR relationship on the right axis, showing the USD ranging from EUR1.20 to EUR1.45. While the magnitude is less, it impacts manufacturing and exporting their products. Even a 20% change on the top line can remove the industry average 6% operating margin. This benefits BMW, which manufactures SUVs in the U.S. Not only is the company effectively hedging its sales to U.S. consumers, the world’s largest market for SUVs, but it also gets to burnish its badge asserting that it’s manufacturing in the U.S.
As the CARZ ETF includes the top ten global manufacturers, foreign exchange impacts will be muted. CARZ’s top three holdings are Ford, Daimler, and Toyota, which should counteract each others’ foreign exchange impacts.