Europe's car crash isn't fatal

According to European automotive industry association ACEA, over 1m fewer cars were sold in Europe last year than in 2011. That’s an 8 per cent fall. Sales in December fell twice as fast. Spain, Italy, Portugal and Greece - Europe's soft underbelly - all failed spectacularly. So did France. Even German autobahns are feeling emptier. Unsurprisingly, it's the volume manufacturers: Peugeot (Fr: UG), Fiat (It: F) and Renault (Fr: RNO), that have fared worst as demand in loyal home markets dries up. And analysts reckon sales in this notoriously cyclical industry could fall further still in 2013.

Deutsche Bank has pencilled in another 4 per cent drop in demand across Europe to 13.5m vehicles, compared with their previous forecast for slight growth to 14.2m. In 2007, it was over 18m and it has been falling ever since. Even in Germany, sales could hit a 20-year low and growth in the UK reverse, warns the broker. Clearly, more factories will close and jobs disappear before capacity shrinks sufficiently to meet weak demand.

There is, however, a clear divide. Premium brands like BMW (Ger: BMW), Porsche-maker Volkswagen (Ger: VOW3) and Mercedes-owner Daimler have all kept a pretty tight grip on sales in Europe. They've excelled in opening up higher margin markets in the Far East, too, and building a presence in the US. That could make the difference to the UK firms that supply them like GKN (GKN), Johnson Matthey (JMAT), Senior (SNR), Ricardo (RCDO), Bodycote (BOY), Alent (ALNT), Castings (CGS), Spectris (SXS) and Trifast (TRI). If Deutsche Bank is right and the current de-stocking cycle in Europe ends next quarter, it will mark a crucial turning point for parts suppliers.

Key battlegrounds

Importantly, few of our manufacturers depend solely on automotive for their livelihood. An "irritation" is how one analyst describes it. And, if you have been plugged into the German giants, you will have done rather well. That’s why, in the absence of London-listed carmakers, we turned last year to Europe's industrial heartland for inspiration. The pickings have been rich. Daimler is up 10 per cent since our buy tip (€40.33, 26 April 2012) and Volkswagen preference shares (€146.1, 18 October 2012) are up 27 per cent.

For Germany's big three, America and China are vital. Over 40 per cent of VW's stable, mostly Audis, end up in emerging markets - about 2.8m in China alone - and the country will be Mercedes' largest market within a couple of years. At BMW, Chinese sales accelerated 39 per cent in the third quarter. Passenger vehicle sales grew 9 per cent there last year, yet a motorisation rate of just 58 vehicles per 1,000 people suggests plenty more growth is to come. Deutsche Bank thinks the luxury end could easily expand by 15-20 per cent both this year and in 2014. Watch out for an assault on India next.

Over in the States, there are fiscal headwinds - higher taxes and, perhaps, cuts in government spending - but demand has been rising steadily. It should again in 2013. Sales should reach 14.8m given an improving economy, high second-hand car prices and easier credit for so-called 'non-prime' drivers. Interestingly, 2.3m new drivers have hit the roads each year in the US for the past two decades and, with US unemployment easing, more of them will buy new.

Each of those cars is packed with about $2,000 (£1,300) of electronic gadgets and circuitry. This was a key themes at last month's Detroit motor show, and it is only going to grow as younger drivers demand voice recognition, touch-screen dashboards and other gizmos. Hybrid and electric vehicles need more tech, too, so content should easily outpace car production. In fact, industry forecasts predict a compound annual growth rate for automotive electronics of more than 8 per cent between 2011 and 2016.

That's exactly what Alent wants to hear. Formerly one half of the Cookson engineering conglomerate, its technology operates car locks, lighting and airbags, and its coatings stop parts from rusting and make chrome bumpers and grills look pretty and last longer. Luckily, a lot of that work is in America and with German brands.

TT electronics (TTG), whose sensors operate power steering and climate control systems, is doing well too. Admittedly, times are tough, but well over a third of sales come from the Germans, mostly driven by strong demand for passenger cars in Russia, Asia and North America. It’s also doing more business with local Chinese manufacturers like JAC, Chery and BYD.

Spreading the risk

Selling your wares to wealthy Germans may still be profitable, but elsewhere it's a struggle. Car sales in France have been falling for a year and in Italy they are at a 34-year low. That swiped 10 per cent off revenues at Senior's passenger car business during the first six months of 2012. Blame Renault and Peugeot for that. Thankfully, it’s a paltry 6 per cent of group sales; work on trucks and aircraft still make up the lion's share of the business.

Bodycote, too, has warned that demand for its heat-treatment processes has died down since the middle of last year. Again, it's valuable aerospace money and energy business that's plugging the gap. Of course, GKN supplies drive shafts and other parts to just about everyone, including VW and the French plants. Yet it’s the luxury end and demand for 4x4s that should allow it to outgrow the market by up to 3 percentage points every year.

Further down the food chain it's easy to forget Trifast, but there's a great story here. Nissan, Jaguar Land Rover, Audi and Volvo buy its nuts and bolts, and the UK automotive industry now accounts for over half its sales. It makes fasteners for electronics manufacturers, too, and a credible self-help story put it on our wish list last summer. Not so Metalrax. A profitable business making lightweight chassis components for Jaguar and locks and handles for Land Rovers is spoiled by an underperforming wine racks and kitchen gadgets division. Steer clear.

Elsewhere, Johnson Matthey, a super power when it comes to catalytic convertors, should clean up as global emissions legislation for both trucks and cars gets stricter over the next few years. Ricardo, a Jaguar Land Rover supplier and another linked more to the development than production cycle, will do well, too. Designing greener, more fuel efficient engines is its bread and butter, and it has just won government funding for a new state-of-the-art £10m vehicle emission research centre at its Shoreham HQ.

Broker view: Capacity cuts essential

European autos team at JP Morgan

European vehicle manufacturers (OEMs) need to take at least 15 per cent of capacity out of the system to be aligned with market demand and finally find a solution for the European Carmageddon. Within the largest Western European manufacturing countries, Italy needs to reconsider the future of its auto industry, with a percentage cut in excess of 30 per cent unless it repositions its footprint as an export-driven auto economy. Spain and France need to take out about 20 per cent capacity each. The UK needs the lowest capacity cuts, while, unsurprisingly, Germany is already at a sustainable capacity level. This would allow OEMs to lower their sales incentives programmes. However, we don’t see supply and demand coming into balance over the next three years, based on their current plans.

We believe the outperformance of auto stocks is determined by the ability to generate a healthy amount of positive free cash flow, and 2013 will be a challenging year for this. Achieving positive earnings momentum will depend on pricing discipline, effective implementation of cost-cutting measures and the ability to capture growth in China.

Only VW and BMW tick all these boxes and we initiate with an overweight recommendation and target prices of €230 on VW and €95 on BMW. The latter is coming off its best product momentum cycle, average age of its fleet is the youngest in the European premium sector and we can rely on it to execute its manufacturing strategy in challenging markets. Auto margins approaching low double digit could still be a reality next year if currency does not turn out to be an incremental negative. Despite their undoubted robust industrial operations we see higher execution risks in 2013 for Daimler (neutral €46), Fiat (neutral €4), Porsche (neutral €88) and Renault (neutral €50) as well as limited earnings potential. We also struggle to see potential in Peugeot’s mid-term plans to turn around its European operations, hence our underweight rating and €4.5 target price.