Conditions on state funding slow auto industry revamp

London: European auto shares are set for another sharp leg down in 2009 as the one factor that can rescue them, restructuring, has become increasingly difficult in a sector dependent on government handouts for immediate survival.

Where companies do manage to keep themselves afloat with the state help, however, the key to survival in the long term will be in cutting chronic over-capacity, drastic restructuring and shifting focus to emerging markets from saturated European markets.

Analysts say that although investors would try to avoid European carmakers over the coming months, there will be a few interesting picks within the sector. Shares of volume car makers will remain under pressure, while companies that target niche luxury markets may again prove interesting.

They say that any meaningful restructuring and consolidation may mean laying off workers, a politically sensitive issue especially in the current environment when the world faces the worst economic downturn since the Great Depression of the 1930s.

"Mergers require financial and political capital to execute, things that auto companies are currently running very low on," said Adam Jonas, European auto analyst at Morgan Stanley.

"The political situation makes it difficult to reduce the tens of thousands of jobs that investors would expect from a mega-merger."

The sector is receiving state help: France pledged to lend 6 billion euros ($7.8 billion, Dh28.6 billion) to Renault and PSA Peugeot-Citroen while Italy announced a 1.2 billion euro package for its domestic car industry.

Analysts say that governments will act to support the sector, but their aid comes with conditions such as maintaining production and workforce, at least for the time being when recession is gripping the entire world.

"There is a massive contradiction between messages that are being sent out in the short term," said Henk Potts, equity strategist at Barclays Stockbrokers.

"The bailouts can prolong the agony in the short term, but the industry does need to face a significant period of restructuring and consolidations in the longer-term. Auto shares are likely to be extremely volatile over the next few months."

Goldman Sachs said in a recent report that the operating environment for major European auto companies continued to deteriorate. It revised its forecasts for 2009, saying global automotive sales and production may fall by 15 per cent and 16 per cent respectively this year, against an earlier estimate of declines of 10 per cent and nine per cent. "In a weak demand environment, we continue to think capacity reduction and balance sheet cushion are key to avoiding recapitalisation/dilution risks in the sector," said Ranjit A. Unnithan, European auto analyst at J.P. Morgan.

"We recommend avoiding carmakers where we see the most severe capacity issues - PSA, Fiat and Renault - as government aid appears to be conditional on no/delayed restructuring."

European automobile shares plunged last year with Renault sinking 81 per cent, Fiat tumbling 74 per cent, Daimler down 60 per cent and BMW slumping 50 per cent. They are down a further 8-40 per cent so far this year.

The DJ auto sector index is down nearly 23 per cent so far this year, the worst decliner after financials. The sector is also costly, forcing investors to stay cautious.

According to Thomson Reuters data, shares trade at 18 times next year's earnings compared with 8.6 times for the broader STOXX 600 index, 5.6 times for banks and 10 times for the defensive drug sector.

"We expect almost universal passing of dividends, at least for the 09E financial year. We believe investors can still afford to underweight the sector," Citigroup said in a note.