Improving global economic conditions and an array of vehicle launches have encouraged customers to buy new vehicles. This, in turn, has increased the demand for components, which has led to amplified sales for the Original Equipment Manufacturing industry over the past few years.

The industry is also likely to get a boost from increased focus on the launch of autonomous and electric vehicles. Also, original equipment manufacturers (OEMs) have to introduce products that comply with environmental and safety standards, along with fuel efficiency to be in sync with regulations passed by various governments. All these evolving needs are expected to increase the demand for automotive equipment. OEMs have to keep on developing technologies to cater to the increasing needs. 

Over the next few years, the industry is expected to benefit primarily from emerging economies compared with the developed ones. This shift will require the OEMs to adapt to changing demand and supply pattern with respect to the production of individual regions. Also, the manufacturers have to develop their supply chain and product portfolio per the requirement of markets.

Industry Comparison with S&P 500, Sector

It seems that the industry’s performance has boosted investors’ confidence in its growth prospects. Frequent vehicle launches with hybrid applications across markets make auto manufacturers look for auto parts. The rise in demand for various types of auto parts has been driving sales at OEMs. The Zacks Auto - Original Equipment Industry, which is a 38-stock group within the broader Zacks Auto Sector, has outperformed its own sector while marginally underperforming the S&P 500.

The stocks in this industry have collectively gained 12.7%, while the Zacks Auto Sector and Zacks S&P 500 Composite have rallied 5.1% and 13.1%, respectively.

One Year Price Performance

 Original Equipment Stocks Trading Cheap

A number of metrics can be used to evaluate the industry’s valuation scenario. However, since the industry that we are discussing here is a capital intensive one, it will be apt to look into EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio or multiple as a valuation metric. We are choosing this metric over others as it considers both equity and debt while ignoring the difference in capital structures and the effect of non-cash expenses.

Despite the industry marginally underperforming the S&P 500, the valuation seems to be attractive. Currently, the industry has a trailing 12-month EV/EBITDA ratio of 7.2, at a discount to the S&P 500’s EV/EBITDA ratio 11.3. As the chart below shows, the industry has traded as high as 8.8X and as low as 7.2X, with a 12-month median of 7.9X.

EV/ EBIDTA Ratio (TTM)

Moreover, a comparison of the group’s EV/EBIDTA ratio with that of its broader sector shows that the industry is trading at a decent discount. The trailing 12-monthsEV/EBIDTA ratio of the Zacks Auto Sector is 8.4, with median level of 8.5, both above the Zacks Auto Original Equipment Industry’s respective ratios. Since the beginning of 2018, the group has been trading at a discount to the sector.

EV/ EBIDTA Ratio (TTM)

 Price Performance Under Strain Due to Bleak Earnings Outlook

Improving economic conditions with high employment rates may support the growth of the industry. Also, changing consumer preference for vehicles will lead to increased demand for high-quality auto components at automotive companies to bring new and better vehicles. This should help the OEM players to continue delivering positive shareholder returns in the near future.

However, it is important to know whether the industry has the potential to perform better than the broader market in the coming quarters. However, an evaluation of the valuation ratios demonstrates that market participants are willing to pay up for these stocks already, potentially limiting further upside from current levels.

A trustworthy option to check the industry’s prospects of a solid performance is glancing through the industry’s earnings outlook of the member companies. Empirical research shows that earnings outlook of the member companies has a direct bearing on the market performance of its stock.

The Price & Consensus chart for the industry below shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. In the chart, the earnings expectation for 2018 is represented by the light blue line, while the red line represents the same for 2019.

Price and Consensus: Zacks Auto – Original Equipment industry

This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Notably, the $4.28 EPS estimate for the industry for 2018 is not the actual bottom-up EPS estimate for every company in the Zacks Auto - Original Equipment industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the EPS of the industry for 2018, but how this projection has evolved recently.

Current Fiscal Year EPS Estimate Revisions

 As you can see here, the $4.28 EPS estimate for 2018 has remained steady since June, previously declining from $4.44 at May-end. Looking at the aggregate earnings estimate revisions, it appears that analysts are losing confidence in this group’s earnings potential.

For full-year 2018, the consensus EPS estimate has been revised 0.5% downward since March 31.

Zacks Industry Rank Indicates Recent Bumps

Moreover, the group’s Zacks Industry Rank, which is actually the average of the Zacks Rank of all the member stocks, indicates underperformance in the near term.

The Zacks Auto - Original Equipment industry currently carries a Zacks Industry Rank #177, which places it at the bottom 31% of roughly 256 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the group’s rank started deteriorating in the last week. However, its rank was in the top 50% industry rank between the eighth and second week.

 Auto Original Equipment Industry’s Long-Term Growth

Since April 2018, the group’s mean estimate of long-term (3 -5 years) EPS growth rate has been increasing to reach the current level of 11.7%, compared with the Zacks S&P 500 Composite of 9.8%. The EPS growth rate figures showcase that the long-term prospect of the industry is promising. 

Mean Estimate of Long-Term EPS Growth Rate

In fact, the basis of this long-term EPS growth could be the revival of the top line of group members since the beginning of 2016.

Revenues – Auto - Original Equipment Market

 Bottom Line

Surge in demand, emanating from growing autonomous and electric vehicles technology, has opened up huge prospects for the industry. However, its performance depends primarily on how it handles transition challenges, which might hurt its earnings. OEMs have to take into account emission standards, specifically for vehicles sold in countries which have strict emission regulations. Also, the companies have to develop and upgrade their offerings to remain on par with the evolving trends in the automotive market. 

All these challenges require increased R&D spending to design innovative products as well as to set up production lines to manufacture these products. In the near term, auto equipment manufacturers have to balance their revenue generation with broader challenges and escalating expenses. However, keeping the long-term expectations in mind, investors could take advantage of the cheap valuation and opt for a few OEM stocks that have a strong earnings outlook.

We have only two stocks from the auto-original equipment industry with a Zacks Rank #1 (Strong Buy), out of which one witnessed positive earnings estimate revisions. Listed below are a few stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #1 or #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Autoliv, Inc. (ALV): The stock of this Stockholm, Sweden-based supplier of automotive safety products has lost 9.5% in the past year and sports a Zacks Rank of 1. The Zacks Consensus Estimate for the current-year EPS has been revised 0.4% upward over the last 30 days. 

Price and Consensus: ALV

Meritor Inc. (MTOR): The consensus EPS estimate for this Troy, MI-based automotive parts manufacturer and supplier has been revised 1.1% higher for the current fiscal year in the last 60 days. This Zacks Rank #2 stock has rallied 21.5% in the past year.

Price and Consensus: MTOR

American Axle Manufacturing Holdings, Inc. (AXL): The consensus EPS estimate for this Detroit, MI-based supplier of driveline and drivetrain systems has been revised 1.3% upward for the current year over the last 60 days. This Zacks Rank #2 stock has rallied 4.3% in the past year.

Price and Consensus: AXL