Description

Share price:

Common (005380): ₩125,000

Preferred (005389): ₩81,000

Market cap:

Common ₩33,940 billion

Preferred ₩21,993 billion

Net auto cash and liquid securities per share: ₩66,936

Book value of finance arm: ₩18,050

2014 net income per share: ₩27,055

Book value per share: ₩212,341

Note: Numbers as of July 10th 2015 

Hyundai is a good business trading at an incredible price. Since 1999, book value has grown by 14.8% per year (despite cash and securities making up a significant portion of assets over this period). Back in 1999, Hyundai produced some of the worst quality cars in the industry and had global market share of only 2.6%. Today, the quality of its cars is industry leading according to JD Power and market share has grown to 10% worldwide in a very short amount of time. Toyota executives have said Hyundai is their most feared competitor. All of this success has been achieved with margins that have averaged much higher than peers. Hyundai has a sustainable cost advantage which is rare in the automotive industry.

Hyundai’s stock price has fallen nearly 50% over the past year, in large part due to an overpriced acquisition of land among other factors. This widely publicized decision by management certainly resulted in an impairment of business value. However, it has also caused the stock to trade at an incredibly cheap valuation. Hyundai preferred currently trades for ₩81,000 or just 3 times 2014 net income of ₩27,055 per share. Additionally, Hyundai has ₩66,936 per share in net cash and securities and a finance arm with a book value of ₩18,050 per share.  When the net cash and securities are added to the book value of the finance arm – investors are getting the auto business for free. The key question becomes when will this value be realized? Hyundai has consistently increased its dividend. In 2014, management raised the dividend 50% and did a small share buyback. Additionally, in the Q2 ’15 earnings release, management committed to raising the payout ratio to 25-30%. This will result in an annual yield of 10% on the preferred.

There are many factors that have weighed on the business and stock price recently. 1) The land purchase. 2) Low fuel prices are boosting sales for SUVs (a segment that Hyundai barely addresses yet) at the expense of fuel efficient cars. This has caused Hyundai’s sales to fall even though their share of the car market has increased in many markets such as the US. Hyundai has begun focusing more on the crossover and SUV segment with products such as the 2016 Tucson. 3) The won has remained strong against many other currencies which has given an advantage to certain competitors such as the Japanese automakers. 4) The world automobile market is below trend with many areas of the world doing very poorly including Europe, Russia, South America and more recently China.

In addition to Hyundai’s cheap valuation and history of success, there are many tailwinds for the business going forward. 1) The automobile replacement cycle is just beginning in the US. Auto sales in the US were below trend from 2008-2013, resulting in a large amount of pent up demand. Automobile sales have lagged the trend line by 14-26 million units and automobiles are the oldest they’ve ever been in the US at 11.4 years. Additionally, the automobile industry is doing poorly in virtually every market outside of the US. Hyundai is poised to benefit if the world automobile market improves. 2) Hyundai is also moving upscale which will increase margins if they are successful. 3) The quality of their cars is now industry leading. According to the 2015 JD Power Initial Quality study, Hyundai now ranks ahead of the Japanese automakers. 4) Although the land purchase for the new headquarters was bad for shareholders, the subsequent outcry may have been the impetus needed for management to take shareholder friendly actions such as increasing the dividend payout ratio.  

Business

Hyundai is a good business and has risen to be the 5th largest automaker in a very short amount of time. Hyundai’s history is very impressive as evidenced by margins vs. peers, how quickly market share has grown, growth in book value, efficiency of operations, and improvements in the quality of vehicles, etc. Toyota has led the mass market automobile industry for many years and management has said numerous times that their most feared competitor is Hyundai (see Fortune Magazine January 5th 2010 - linked to below).

In 1999, Hyundai and Kia had global market share of 2.6%. In 2009, it grew to 4.4% and in 2013 it reached 10%. Sales have increased every year through this period even during the financial crisis of 08-09. In the first nine months of 2009, US sales for GM, Ford, Chrysler, Toyota, Honda and Nissan ranged from -25% to -50% from the previous year. However, Hyundai was all by itself registering a 2.6% increase in sales and gaining 2.2 percentage points of market share. This is quite a remarkable performance. Hyundai thrived during the worst period in US automotive history. Hyundai was also the largest beneficiary of the US automakers shedding dealers during the financial crisis and was able to scoop up many of the dealers the Big 3 shed during this time. All of these gains were achieved with Hyundai not yet entering the light truck market, which is 50% of US auto sales.

Since 1999, Hyundai’s book value per share has increased from ₩26,751 to ₩212,341 as of December 31^st, 2014. That equates to growth of 14.8% per year before including dividends (which have averaged 1% of book value per year). Additionally, over this period, cash and securities has been a major component of book value.

Hyundai’s margins have been better than peers over time. From 2009-2013 (a period market by major turmoil in the global automotive industry), operating margins have averaged 9% which is the highest of all peers. Over this same period, Toyota averaged 2.84%, Volkswagen averaged 5.3%, Nissan 5.5%, Ford 4% and Honda 4%. Going back even further from 2000-2014 Hyundai’s operating margins averaged 7.67%. Hyundai’s margins are similar to that of luxury automakers such as Daimler and BMW.

There are likely numerous factors behind the margin advantage and it has endured over time. Hyundai’s advantage varies by market. Korea is Hyundai’s strongest market and it has maintained very high market share in the domestic market with 70% share in 2014. Hyundai also has advantages outside of the domestic market as evidenced by the discussion of performance in the US above. Hyundai’s cost advantages also extends worldwide. Hyundai has maintained very high capacity utilization (100% on average from 2008-2013) as well as very low inventory levels. Since 2000, the average mass market automaker has averaged 80% capacity utilization. Hyundai has avoided large markdowns and incentives in part due to keeping inventory levels low. Hyundai is vertically integrated and benefits from access to cheap energy and cheap raw material inputs (cheaper steel from affiliate Hyundai Steel). Unlike many global peers, Hyundai doesn’t have any large pension or healthcare obligations. Hyundai has also favored fewer but larger automobile production facilities. Larger facilities are one of the rare ways that automakers get a cost advantage through economies of scale. Hyundai has pursued this strategy across the world. The Ulsan facility is the largest automobile factory in the world, producing over 1.5 million vehicles per year. Hyundai’s Alabama facility started production in 2005 and produces 370,000 units per year and has ranked number one in the US for productivity since 2009. Hyundai’s Jeonju plant in South Korea also is the largest commercial vehicle facility in the world.

Improving vehicle quality

In 1999, leadership passed to Chung Mong Koo from his father and founder Chung Ju Yung. In the 90’s, Hyundai’s focus was on how quickly it could grow, rather than how good it could make its cars. This all changed in 1999 as the focus became quality. Chairman Chung began attending the twice monthly quality meetings. Hyundai has followed a similar path as Toyota, although it’s taken much less time for Hyundai to go from very poor quality cars to a quality leader. Market perception tends to significantly lag improvements in quality and continued improvement in perception bodes well for Hyundai going forward. In 2001, Hyundai ranked at the bottom of JD Power’s Initial Vehicle Quality study after 90 days of ownership (32nd out of 37) and after 3 years of ownership Hyundai ranked 35th out of 38. In just 3 years, it rose to 7th in the 2004 study and in 2009 was ranked 4^th with Lexus, Cadillac and Porsche finishing ahead of it. That year the goal was to get both brands in the top 3 within 5 years. And in 2015, Hyundai/Kia become the number one mass market automobile manufacturer.  Hyundai was 4th and Kia finished 2nd, surpassing the Japanese automakers for the first time.

Source: http://www.latimes.com/business/autos/la-fi-hy-jd-power-quality-rankings-20150617-story.html

Hyundai has a history of making big goals and holding its leaders accountable to them. Interestingly, Hyundai has achieved this by vertically integrating and developing technologies in house. It’s the only major automaker that has no joint ventures, alliances or partnerships.

John Krafcik left Ford in 2003 after 14 years and as the top deputy to Jac Nasser to become CEO of Hyundai America. He was the 5th leader in six years, the previous four didn’t meet tough goals set by the Korean bosses. In 2010, Krafcik referred to his employer as, “the hardest working company on the planet.” Hyundai has the ability to move quicker than rivals. “One of the reasons we move fast is fewer people,” he says. “Speed doesn’t suffer bureaucrats well.” Hyundai is often incorporating the latest technology into its new cars a month before they are released, rivals often do so 5 months before production. Given its history, Hyundai’s goal of being the 2nd largest manufacturer of green cars in the world by 2020 is likely to be achieved.

Perception of quality tends to lag actual improvement and that bodes well for Hyundai going forward. Intrabrand values Hyundai’s brand at $10.4 billion in 2014 compared to $5 billion in 2010.

Reading:

How the Korean Automakers Beat out the Japanese (Fortune): http://fortune.com/2015/06/29/korean-japanese-cars-quality/

Hyundai: The newest U.S. auto power (CNN Money): http://money.cnn.com/2009/10/20/news/companies/hyundai/?postversion=2009102011

Hyundai Smokes the competition (Fortune): http://archive.fortune.com/2010/01/04/autos/hyundai_competition.fortune/index.htm

Tailwinds

Improving world auto market and Replacement cycle in the US

The majority of the world’s automobile markets are below trend line with depressed sales in Europe, Russia, South America etc. Additionally, the US market has a significant amount of pent up demand that will likely support automobile SAAR for an extended period of time.

There is a significant volume of pent up demand for automobiles in the United States. Over the past 40 years, US auto sales have fallen below 15 million units (population adjusted) in only two periods (1981-82) and (2008-2012). The dynamics that occurred in the early 80’s are similar to what’s happening today. Peter Lynch devotes an entire chapter in his book “Beating The Street” to this. In the 4 years from 1980-1983, the economy was sluggish and people were trying to conserve money. During these 4 years, actual automobile sales lagged the trend line by 7 million vehicles. 7 million people had put off purchasing a new car or truck. Then from 1984-1989, auto sales were above trend line by a combined 7.8 million units.

The only other period in the past 40 years that US auto sales breached the 15 million unit level was 2008-2012. The lull in auto sales was 50% longer this time and was much deeper than in the early 80’s. Population adjusted, auto sales reached a low of 14 million units in 1982 and in 2009 actual auto sales were significantly lower at 10.4 million units. And this was artificially supported by government efforts such as cash for clunkers which boosted auto sales in 2009 by an estimated 550,000. So it’s no surprise that the amount of pent up demand is much larger this time than in the 80s. This time, using the same criteria that was used to calculate the amount of pent up demand in the 1980s period, the amount of pent up demand for light vehicles in the US is likely between 14 million and 26 million units. The trend line is simply the average population adjusted US SAAR over the past 40 year which is 17.3 million units per year. Using the average population adjusted SAAR for the past 40 years as the trend line results in a deficit of 24.78 million vehicles. Further supporting this, the average age of a US automobile reached an all time high in 2013 at 11.4 years. Prior to the recession in 2005, the average age stood at 9.6 years. To reduce the average vehicle age back to the pre recession level would require 19.5 million of the oldest vehicles in the US auto fleet to be replaced with new vehicles. Substantially increased fuel economy, new technology and better quality automobiles are likely to further incentivize the replacement cycle.

Peter Lynch discusses this at length in his book, Beating The Street, “After four or five years when sales are under the trend, it takes another four or five years of sales above the trend before the car market can catch up to itself. If you didn’t know this you might sell your auto stocks too soon.”

"The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside." (One Up p.231)

To purchase and finance an average priced new car required 23.2 weeks of median family income today. This is very close to the all time most affordable period.

Outside the US market, the rest of the world also has a lot of potential to improve. The majority of the world’s auto markets are struggling. Europe is doing poorly with both Italy and Spain at less than 50% of trend line. Also doing poorly are Russia, and South America. Improvement in the world auto industry is a major tailwind. Hyundai is well diversified across the world and will benefit if these markets improve. The largest portion of Hyundai’s 2014 net income came from the domestic market (26.9% of net income).  Additionally, 28% of total net income comes from vehicles produced in Korea and exported around the world. This is tough to properly allocate but a large portion goes to Africa and Europe. A smaller portion goes to North and South America. The remaining net income breakdown is 13% North America, 7% Europe, 13% China and 3% to Russia, Australia, and India. The last 11% is made by Hyundai’s finance operations.

Goldman Sachs estimates the world automobile industry will grow to 104 million units per year by 2020, an increase of 26% over 2013’s total of 82.8 million (growth of 22 million units). This is led by emerging markets such as China (contributing 9.7 million units) and recovering Europe, contributing 5 million units. History suggests growth for automobile penetration is highest as economies pass through GDP per capita of $2,500-$7,500/ year. Many emerging markets are beginning or are in that stage such as China, India and Indonesia. In the US there are 809 light vehicles per capita. In OECD countries, there are 410 cars per 1,000 people. In the BRICS countries there are only 50 cars per 1,000 people.

If Hyundai is successful moving upscale into the luxury segment – margins will grow

Hyundai has also begun to introduce more luxury models. Both the Genesis and EQUUS are going after a market that includes the BMW 5 and 7 series, Cadillac CTS and vehicles from Mercedes and Lexus. If Hyundai can succeed they will earn higher margins than the mass market automobiles it currently sells. For example, Lexus has margins that average 17-20%. Hyundai has hired some of the best talent in the industry to join its luxury segment. In December of 2014, Hyundai poached the chief engineer of BMW’s M performance line and in January of 2015, Hyundai poached the former head of design for Lamborghini and Bentley.

Source: http://www.autoblog.com/2014/12/22/hyundai-poaches-bmw-m-engineering-chief/

Source: http://indianautosblog.com/2015/06/luc-donckerwolke-move-to-hyundai-181810

Management and the potential for an increasing dividend

Increasing market share, high margins and a high ROE are all evidence of a good business in what traditionally has been a commodity industry that destroys capital. Hyundai’s management team has done a very good job growing the value of the company over time. However, there has been much written about the September 2014 land acquisition in which Hyundai management overpaid for a prized parcel of land in downtown Seoul for a new headquarters. This is certainly an action that resulted in a permanent impairment of capital. If these types of actions continue, Hyundai deserves to trade at the multiple it’s currently at. But it’s worth pointing out that Hyundai’s stock price declined more than 3x the amount they overpaid for the land in the months after the announcement and has fallen even more since. In response to investor uproar, management increased the dividend by 50% and made a commitment to increase the payout ratio to 25-30%. They also did a 1% buyback. The market is justified in penalizing Hyundai for overpaying for the land but Hyundai would not have had a nearly 10x increase in tangible book value per share since 1999 (15% per year), a high ROE and all the success they’ve had growing market share if management had destroyed value over time. When Hyundai management implements the 25-30% payout, the yield on the preferred will likely be over 10%.

Valuation

By any measure, Hyundai is trading at an incredible price. The 3^rd preferred trades for ₩81,000 and had earnings of ₩27,055 in 2014. Before subtracting net cash and securities, Hyundai preferred is trading at 3 earnings.  Cash, short term investments, public securities at market value net of auto debt is equal to ₩66,936 per share. The three finance businesses have a book value of ₩18,000 won per share. When net cash and securities are added to the value of the finance arm – investors are getting the automobile business for free.  

Catalyst

1) Value is its own catalyst and Hyundai trades at 3x earnings before subtracting net cash and securities. 2) Growing dividend payout. Currently at a 5% yield and management has recently indicated they will raise the dividend payout ratio to 25-30% which equates to a 10% yield. 3) Most of the world's auto markets are below trend - Europe, Russia, South America etc. And the United States has a significant amount of pent up auto demand. 4) The quality of their automobiles is now industry leading and ahead of the Japanese automakers. 5) Hyundai is moving into markets they haven't addressed in the past such as luxury and light trucks.