Although there are undeniable challenges for all automakers, Subaru (OTCPK: FUJHY) remains an attractive recovery story. Currency markets and supply chain issues will persist over the medium term. However, at low valuations and a strong balance sheet offering defensive qualities, we reiterate our Buy rating.
Formerly known as Fuji Heavy Industries, Subaru was founded in 1953 to produce and repair aircraft. The current automobile lineup includes the Legacy, Forester and Outback. The company originally had a close alliance with Nissan Motor (OTCPK: NSANY), but since 2005 has been part of Toyota Motor(TM). Toyota Motor owns a 20% stake in Subaru.
Key financial data with consensus forecasts
We want to reassess our buy rating from February 2021 on the basis of a cash-rich balance sheet and a PBR at 0.9x, given a 25% share price correction. As global shortages of semiconductors and electrical steel continue to impact the automotive industry, we take a look at where Subaru stands in terms of production capacity, currency impact and manufacturer strategy with BEVs (battery electric vehicles).
In terms of share price performance relative to its major peers, Subaru has relatively outperformed based on a strong balance sheet and a demand profile that is relatively unaffected by macroeconomic conditions compared to manufacturers with a wider customer base such as Ford (F), Volkswagen (OTCPK:VWAGY), Nissan and Toyota.
Production capacity under pressure
During the FY2022 report in May 2022, Subaru’s management outlined its plan to produce 1 million units (+27.3% YoY) in FY3/2023. Although this was seen as aggressive, management mentioned that it was more of an aspiration, given the continued pressure of the shutdowns in Shanghai.
During the first quarter of fiscal year 3/2023, the company did not change this production target and also maintained the annual sales volume forecast of 940,000 units. However, the continued shortage of semiconductor supplies and lockdowns in Shanghai led to a temporary suspension of operations at domestic production bases for a total of four days.
In terms of raw materials, all car manufacturers have increased their stocks in order to avoid shortages leading to line stoppages. Precious metal prices have come down significantly year over year, but unfortunately other steel materials, aluminum and resins are all on the rise right now. Consequently, there may be new supply issues as well as inflated manufacturing costs in order to meet volume goals.
There will be no dramatic changes in the supply chain or normalization of commodity prices in H2 FY3/2023. Therefore, we conclude that in the short to medium term, Subaru will have limits on its manufacturing output. This is unfortunate in two respects. First, backorders (orders for products not available in stock) in the key US market would be high. Second, despite growing concerns about consumer sentiment, there doesn’t appear to be an urgent need for the company to revise its pricing or increase incentives.
The longer-term challenge for Subaru is a strategic shift to base dedicated production in Japan for next-generation e-Boxer EV cars. Capital expenditure is expected to increase significantly from FY 3/2024 and as a result this will put some pressure on free cash flow generation. This project will take time to materialize, with production expected to start in 2027.
Keep an eye on the FX
As the Japanese yen firm indicates, the rapid depreciation of the currency should be seen as a positive for this partially exporter. However, any business with a global footprint will face challenges if exchange rates have moved as aggressively as they have over the past 6 months. Management was surprisingly open when it said that starting with the first quarter results of fiscal year 3/2023, it was difficult to be “optimistic or pessimistic”.
The weaker yen led to higher provision charges for product warranties, and cars held in inventory had to be revalued upwards in yen, erasing unrealized capital gains. However, what is clearly positive is that Subaru managed to sell 20,000 more units year-over-year compared to the same period last year. Underlying demand looks firm, but currency fluctuations could prove key to the end of the year.
The continued depreciation of the Japanese yen will result in continued recognition of rising product warranty costs. While raw material costs will increase in yen terms (as most are purchased in US dollars), the overall cost pressure will likely cause product prices to increase or adjust adversely, which could negatively impact demand, as well as more favorable incentive conditions.
On a positive note, Subaru has forecast a JPY 104.2 billion/USD 0.7 billion increase in raw material costs for FY3/2023, compared to an actual expense of only JPY 17.1 billion/USD 0.12. billion USD for the first quarter of fiscal year 3/2023. . Although we expected FX to have a negative impact on earnings in H2 FY3/2023, it appears that Subaru has some buffer built into its forecast, although it is suspected that no one expected the dollar is trading at JPY145 as it is today (the company’s assumption is currently unchanged at JPY120).
The consensus forecast for FY3/2023 remains significantly higher than the company’s forecast (sales of 2 trillion yen, operating profit of 200 billion yen). Of these figures, the shares are trading at PER FY3/2024 7.6x with a free cash flow yield of 11.2%. Subaru’s balance sheet remains grossly overcapitalized with more than 50% of market capitalization in net cash (excluding auto finance portfolio).
Valuations remain cheap, and while consensus forecasts may be overly optimistic, we believe that as the auto industry continues to adapt and adjust its supply chain, product manufacturers niche products such as Subaru will continue to recover.
The upside risk comes from a stabilizing currency market leading to a slow return to normalized trading conditions. Although it will still take time, Subaru demonstrating its ability to manage its supply chain more effectively will be a positive catalyst for its sales cycle.
For downside risk, continued yen weakness will wreak havoc with costs for Subaru for both supply and product warranties. The other concern is consumer health in the key US market, and whether demand will remain relatively robust in the face of a recessionary environment.
While there are undeniable challenges for all automakers, Subaru remains an attractive recovery story. Its specialized offer in off-road utility vehicles/SUVs remains in demand and its product portfolio for BEVs is becoming clearer. While we wouldn’t recommend an overweight in the automotive sector, exposure to Subaru looks more defensive than its peers. We reiterate our purchase rating.