Stock Grader: Is Honda a Great Value Play on Cheap Gas in 2015?

by Ryan Fitzwater, Director of Research, The Oxford Club
stock-grader-honda-value-play-cheap-oil-2015

Have you noticed a school of new cars taking up lanes on the highway? You’re witnessing one of the many effects of oil’s fall from grace.

You see, as oil prices continue their plummet to 5 1/2-year lows, more motorists are in the right mindset (and have the extra cash) to pick up a new ride.

2014 was a banner year for many car manufacturers. And 2015 is geared up to continue this trend as oil futures are expected to trade in the $50 range well into 2016.

Of course, a strengthening economy and employment growth also plays into the mix, but there is no denying plummeting oil is one of the main culprits.

And with a major boost in December vehicle sales, thanks to cheaper gas spliced across the U.S. and discount deals, Honda Motor Co. (NYSE: HMC) has come onto my radar screen for two reasons:

  1. Honda just posted its best year for new vehicles sold. It pushed 1,373,029 new cars and trucks off its lot in 2014. And December was a recording-breaking month, with 137,281 new vehicles sold during the holiday bustle. With domestic crude hitting $50 for the first time since April of 2009 on Monday, the new car shopping trend has the gas price support to carry on.
  2. Honda might be an oversold and undervalued play. Poking around the world of car manufacturing stocks, it’s surprising to see Honda trading at such low price valuations. Its current price-to-earnings (P/E) ratio is 9.70 and its price-to-book (P/B) ratio is 1, well below the industry average of 1.59. Not to mention it trades at a 0.55 price-to-sales (P/S) ratio. These metrics scream deal.

When an undervalued stock finds itself in an environment where a lower-priced commodity (in this case oil) can help boost its sales and lower its cost (transportation of vehicles, etc.), you would think it is a no-brainer time to load up on shares. But not so fast...

Digging Deeper

At first glance, you might assume Honda’s downfall was probably related to the Japanese stock market as a whole or just an underperforming auto industry sector.

But as you can see in the chart, Honda did not trade in lock-step with its broader domestic market (the Nikkei 225) over the last 12 months. In fact, it moved in the opposite direction.

And while the auto industry as a whole, measured by the First Trust Global Auto ETF (NYSE: CARZ), was down 8.13% over the last year, Honda underperformed its peers dramatically, down 28.59% over the same period of time.

Due to the fact that Honda beat consensus earnings estimates three out of the last four quarters, earnings surprises clearly were not the cause.

So upon further analysis, it appears recalls are playing into the price drag.

Airbag Recalls

Four deaths have already occurred in the U.S. and one in Malaysia due to defective air bag inflators provided by a company called Takata. As a result, the U.S. and other governments asked for a nationwide recall of certain Honda vehicles.

It is important to note that Honda is not the only car manufacturer involved in a global airbag recall, but it is currently the manufacturer with the most recalls. It has recalled over 14 million cars making up more than 60% of the 21 million total recalls. Plus the four people killed in the U.S. were driving Honda-manufactured vehicles.

Other automakers affected include BMW, Toyota (NYSE: TM), Mazda (OTC: MZDAF), Subaru, Nissan (OTC: NSANY), Mitsubishi, General Motors (NYSE: GM) and Ford (NYSE: F).

Unfortunately, Honda entered into the airbag mess with an already dented reputation. The redesigned Honda Fit had already been recalled five times when the Takata airbag situation took off.

The PR Game

In an effort to curb public outcries amid growing recall announcements, Honda’s CEO announced he was taking a 20% pay cut for three months in October of 2014. Members of the board also took 10% pay cuts.

It is important to note that recalls are baked into the automotive industry. They happen due to human error, and until we invent a magic pill to cure mistakes, they will continue their existence. Until then, we hold those responsible for mistakes the best we can, and that includes affecting their bottom line by requesting or requiring recalls.

And I will give a sliver of credit to Honda here. First, the company reacted promptly to the U.S.’s recall requests. Chrysler Group, Ford, BMW and Mazda are still up in the air on nationwide airbag repairs.

Second, in the face of a horrible recall situation, its executive and board members took a pay cut. Meanwhile, General Motors CEO Mary Barra and its executive team didn’t see a single drop in their take-home pay amid their company’s ignition recall crisis.

Not to mention Honda’s executives make a fraction of what U.S. auto executives make. Honda’s CEO, Takanobu Ito, made $1.3 million in the most recent fiscal year, while Mary Barra’s total compensation package is more than $14 million a year. But I’ll get off my soap box and get back to evaluating Honda.

Facing Headwinds

Since October, the company has announced more recalls. The total costs of these can be hard to predict, so it’s difficult to be confident about any earnings outlook. Investors should remain cautious.

However, with the stock already trading close to book value, even it if falls a bit more, the drop is likely to be temporary. In the long-term, this could be a great buying opportunity. Honda’s earnings are projected to build steadily over the next four quarters.

Of course, in the end, projections are just educated guesses about the future. If we want to see how Honda is positioned today, we need to look at its current financial health.

Let’s see how Honda performs on our patented Investment U Fundamental Factor Test. This will help us gauge if it is well-positioned to benefit from lower gas prices and how equipped it is to weather developing recall situations.

Earnings-per-Share (EPS) Growth: In the most recent quarter, Honda saw its earning jump 17.51%. Double-digit growth is good to see.

Price-to-Earnings (P/E): As I already noted, Honda’s P/E is 9.70. The auto industry is averaging 10.62.

Debt-to-Equity : Honda’s debt-to-equity is 96.43%. That might seem high, but auto manufacturing is a capital-intensive industry, with an average debt-to-equity ratio of 128.10%. Honda looks properly leveraged here.

Free Cash Flow per Share Growth : Honda saw free-cash-flow drop 41.06% last quarter. With recalls still rolling in, cash flow growth could continue to be an issue. Hopefully it can turn this around.

Profit Margins : Honda’s profit margins of 4.71% are slightly below the industry average of 5.11%. It misses the mark here.

Return on Equity : Honda ends our last metric on a negative note, splitting the test results. Its ROE of 10.51% is almost five points below the industry average of 15.11%.

It’s clear that investors should still remain cautious with Honda. While it is trading at attractive prices and looks to benefit from lower gas prices, the potential fallout from recalls and its current financial health looks cloudy.

*Why did we look at these specific metrics? Find out more here.

Fundamental Factor Test Score

C: Hold (Hits just three key metrics)

Please note that our fundamental factor checklist is just the first step in performing your own due diligence. There are many other factors you should consider before investing. That’s why The Oxford Club offers over a dozen newsletters and trading advisories all aimed at helping investors grow and maintain their wealth. For more details, click here.

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