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Monday, November 24, 2008

While Detroit Dies, Honda Gears up for Recovery

STUCK IN LOS ANGELES TRAFFIC OR ROLLING along a Southern California freeway, the Honda FCX Clarity looks like any other small four-door sedan. But the Clarity -- 200 are now on the road, all leased to drivers living near Santa Monica -- is powered by a hydrogen fuel cell. It gets the equivalent of 74 miles a gallon (or, more accurately, 72 miles per kilogram of hydrogen), can travel nearly 300 miles between refuelings and sends water vapor, not pollutants, through its exhaust pipe.

The Clarity appears to be more advanced than the fuel-cell vehicles being tested by other auto makers. Still, you won't be able to buy one soon. Though Honda theoretically could start mass-producing the Clarity in three or four years, the car wouldn't sell unless a nationwide network of hydrogen-fueling stations existed -- and that, even with government support, could take at least a decade.

But Honda (HMC: 20.31, +1.17, +6.11%) is more than a technology leader, and that's why, despite the global car market's current misery, any investor with a long-term view should consider its stock whenever signs start to emerge of an upturn in the auto industry.

AMID A SAVAGE SALES SLUMP that has led the Detroit Three to plead for government aid, threatens to bankrupt General Motors and has battered most European and Asian vehicle makers, the Japanese car manufacturer is a standout. In this year's first nine months, Honda was one of just two car companies (the other being Subaru) whose U.S. sales were up. In August, its share of the U.S. market was a record 11%, making it the No. 4 auto maker, behind GM, Ford and Toyota, but ahead of Chrysler.

Recently, however, the downturn's severity has taken a toll on Honda. Its U.S. sales plunged 25% in October, but that still was better than the overall industry's 32% slide. Honda now expects its 2008 U.S. sales to be off 2.4%, the first yearly decline in 15 years. But the company remains confident; it will open a new plant this month in Greensburg, Ind., that soon will be turning out 30,000 vehicles a month. And it has opted not to follow Toyota, Nissan and others in offering 0% financing.

If the global auto industry is headed into "outright collapse in 2009...with a recovery at least 18 months away," as the auto research firm J.D. Powers has warned, Honda won't escape hard times. But it will survive and be a winner after the downdraft ends.

"Honda is first and foremost an engineering company, with a philosophy of efficiency that is driven to get more out of less," says John Casesa, a former Wall Street auto analyst turned managing partner of New York's Casesa Strategic Advisors. "The people who run the company are the people who design, manufacture and sell the cars, people who have a passion for the business. Honda is the best-positioned of any car maker to ride out this storm, and the best-positioned for a recovery. The stock is as close to being a blue chip as exists in the auto industry today."

After changing hands at 36 last summer, Honda's Big Board-traded American depositary receipts plunged late last month to a 56-month low of 18.94 after the company reported a 41% decline in second-quarter operating income per share to 69 cents. But they quickly bounced back to their current level in the low 20s.

PREDICTING EARNINGS EVEN FOR the rest of this year, let alone 2009, is treacherous in this kind of environment, especially with the Japanese yen moving up lately against the dollar and the euro. Every one-yen change against the dollar boosts or lowers Honda's annual operating profit by 18 billion yen (about $180 million). However, the company recently trimmed its 2008 operating-profit expectations 13%, to ¥550 billion ($5.5 billion) and cut its net income forecast 2%, to ¥485 billion ($4.8 billion, or about $2.70 an ADR). As of Sept. 30, Honda had about $9.25 billion in cash and equivalents and around $22.25 billion in long-term debt, and its cash flow was strong.

Honda shares carry a dividend yield of about 3% and trade at a price/earnings ratio of just under 9 based on expected 2009 earnings -- close to a 10-year low. "At this price, we have a Strong Buy on the stock," says Steve Usher, an analyst with JapanInvest. "Honda is our preferred auto stock. It is a quality stock with tremendous value and potential."

The Japanese company gets almost 30% of its operating returns from non-auto businesses, most notably motorcycles, power equipment, lawn mowers and marine engines. Motorcycles, with models ranging from heavy to light, are selling especially well in Brazil and Southeast Asia. The company also has a unit called HondaJet -- small and not profitable, but promising -- that soon will start selling light corporate aircraft.

Honda's biggest market, North America, accounts for about 45% of its total operating profit. But expanding outside Japan and North America is an important aim for the company, especially because its operating margins elsewhere in the world are up to four percentage points better than those in North America and seven points better than those in Japan.

Ever since the company brought its first car to the U.S. 39 years ago -- the tiny two-door N600, which drew sneers and jeers from Detroit -- it's been known for fuel-efficient small cars. That's now a huge advantage.

While Honda's lineup has since grown to include the luxury Acura line, the Ridgeline pickup and the big Pilot SUV, its top sellers remain the midsize Accord and compact Civic, both of which deliver more than 30 miles per gallon on the highway. It has roughly a 65-to-35 mix of cars to light trucks, but is almost unique among large auto companies in not making a V-8 or deeply participating in the truck and SUV craze prevalent in the U.S. until two years ago.

Honda has another advantage: Not only are its U.S. plants non-unionized, but all are also among the industry's most flexible. Honda's models are designed to use common parts as much as possible and to be assembled much the same way. Its heavily robotized production lines can switch from making any one model to another in five to 10 minutes, versus days or weeks at rivals' plants. This helps produce vehicles that are uniform in quality; they're often among the top performers in the reliability ratings done by Consumer Reports and J.D. Powers. And it has allowed Honda to quickly match swings in demand, as it did this year when sky-high gas prices slashed Pilot sales and boosted those of small cars.

The company is also beginning a mini-new-product blitz. It just introduced a redesigned 2009 Fit subcompact, which has been flying off dealers' lots (but not fast enough to offset sales declines for other models). "This is the right car for the right time," says Dan Bonawitz, head of corporate planning and logistics at American Honda Motor. "It's small on the outside, big on the inside."

The Ridgeline truck and Pilot have been redesigned for 2009, and the Accord, Civic, Element and compact CR-V sport-utility vehicle will get redesigns over the next two years. Also updated will be the Odyssey minivan -- the first Honda that will offer the company's new V-6 diesel, which it claims will be so low-polluting that it can be sold in every state without the urea emission-control systems that BMW and Mercedes-Benz are putting into their newest diesels.

AT THE RECENT PARIS AUTO SHOW, Honda took the wraps off a hybrid-electric Insight, which has a new type of engine that will allow it to be driven on battery power alone. When it comes to market next summer, it will match the top-selling Toyota Prius in mileage and performance, while boasting a starting list price under $20,000 -- about $3,000 less than the Prius and Honda's own Civic hybrid.

Unfortunately, at the moment, all the positives are being offset to a large degree by the global economic slowdown, the continuing worries over credit availability and the possibility that the yen will keep rising against the dollar and euro.

But, eventually, the economy and financial markets will heal. And Honda, with its fuel-thrifty cars, flexible assembly plants and advanced technology, will emerge as one of the auto industry's few big winners.

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