Hefty Warranty Costs
The author is an analyst of NH Investment & Securities. He can be reached at soohong.cho@nhqv.com. -- Ed.
HMC and Kia’s setting of large additional warranty provisioning for their theta engines is a disappointing event in terms of investor confidence. But, an accompanying share price shock should be limited to the short term. With ROE continuing to rise in response to successful new model launches, the domestic automakers’ P/B is still less than 1x. Noting improved fundamentals, our expectations remain intact towards a mid/long-term share price uptrend.
HMC/Kia: 3Q20 turn to red inescapable given hefty warranty costs
In an IR presentation yesterday (Oct 19), Hyundai Motor Company (HMC) and Kia Motors (Kia) announced that they will set additional 3Q20 warranty provisioning of W2.1tn and W1.3tn, respectively, in response to quality issue costs for their theta engines (mid-sized engines used in the Sonata). Given such, HMC and Kia’s 3Q20 earnings releases are inevitably to show a turn to large-scale operating losses.
The main factors that have prompted the additional provisioning are: 1) higher predicted costs due to reinforcement of a pre-failure detection function after applying the Knock Sensor Detection System (KSDS), an engine vibration monitoring system installed since 2019; and 2) a higher engine replacement rate versus the previous projection; and 3) a recalculation of vehicle operation period (12.6 → 19.5 years) in accordance with the implementation of a lifetime warranty.
The additional provisioning is to undermine investor confidence as management had previously said that most of last year’s predictable costs were already reflected and that the possibility of booking further provisioning would be low. Of related note, HMC and Kia (combined) recorded provisioning of W460bn for 3Q18 (HMC W300bn; Kia W160bn) and W900bn (W600bn; W300bn) for 3Q19.
Share price shock to be limited to short term; adhere to Positive rating on sector
While yesterday’s news is disappointing event in terms of investor confidence, any accompanying share price shock is unlikely to be significant or lengthy, considering: 1) expectations remain intact towards earnings improvement from 2021; 2) HMC and Kia’s shares are still trading below the 1x P/B mark (currently around 0.6x) at a time when their ROEs are transitioning to long-term upcycles; and 3) intrinsic corporate value should continue to strengthen next year with a virtuous cycle being in play thanks to successful new model launch effects.
We anticipate that a successful new model effects-sparked virtuous cycle effect started in the domestic market this year will expand to the US and EMs by next year. Looking at the current product cycle, earnings momentum should hit its strongest point in 2021, with accompanying margins hitting full stride over 2022~2023. Accordingly, we adhere to a Positive investment rating for the auto sector. We suggest that investors concentrate upon HMG members (HMC/Kia/Hyundai Mobis) and certain components makers, pointing out high growth potential thanks to their sustainable investments in electrification.