Stock Quotes in this Article: F, GM

NEW YORK (Stockpickr) -- After a gut-wrenching industry downturn in 2009, the auto industry began to stage a remarkable recovery in 2010, and investors began to look further down the road to even more gains. Almost every company shed a huge amount of fixed costs and looked poised for record profits as industry sales volumes slowly rebounded.

Shares of Ford Motor (F), for example, quickly surged to nearly $20 by early 2011. And GM’s (GM) late-2010 IPO saw such a hearty reception that investors scored a quick 20% gain in just a few months. Many auto parts suppliers also saw their shares rise up to fresh post-crisis highs.

And then, the bottom fell out -- again. Ford, GM and those suppliers have seen their stocks fall 30% or even 40% from those peaks over the last year as investors suddenly lost their enthusiasm for this resurgent sector.

>>5 Cash-Rich Stocks to Buy in 2012

Remarkably, the auto industry’s outlook is even brighter than it was a year ago, and for investors willing to ride out the storm, major gains can be made.

For specific auto industry stocks to consider, check out "5 Cheap Stocks for an Auto Industry Renaissance."

The Leverage of Volume

After selling 16 to 17 million units annually, the auto industry suffered a massive shock as industry volumes fell to just 10.4 million. Decent profits morphed into huge losses, sending some players into bankruptcy, while others barely stayed afloat. Many auto parts suppliers saw their stock move below $1.

But that shock may have been the best thing to ever happen. In an industry known for bloated cost structures and barely competitive products, the systemic shock led to a wave of cost cuts and better product line-ups.

Just a year after the nadir of the economic crisis, profit margins started to sharply rebound, and with lower costs in place, those were on path to reach record levels in just a few short years. Though industry sales rose just 11% in 2010 to 11.55 million units, almost every industry player managed to move back into the black.

Ford, as an example, saw operating profit margins rebound to 5.8% that year, the company’s best showing in a decade. The company’s stock rallied in 2010 as investors started to anticipate how much higher those margins could rise as the auto industry got back on its feet.

The Pause Before the Next Move Up

In hindsight, investors jumped the gun on the industry’s profit margin surge. A rebounding economy meant that prices for raw materials such as steel and rubber moved back up from decade lows. Labor expenses, which had fallen dramatically thanks to revised union agreements, needed to tick back up as delayed raises and bonuses were finally granted. Perhaps of greatest concern, signs emerged that Europe was entering into a downturn that would lead to moderately falling sales on the Continent.

Over the course of 2011, investors had to digest these headwinds, and expectations that industry profits would keep growing had to be curtailed. Ford for example suffered from rising expenses, saw operating income rise just 3% in 2011, half the rate of sales growth.

The Coming Profit Surge

To be sure, Europe will remain a headache for this industry, at least for the rest of 2012 and perhaps 2013 as well. That explains why this group remains out of favor, with many leading stocks sporting P/E ratios in the mid-single digits. That dowdy valuation seemingly ignores the coming industry momentum that investors will see as we head towards the middle of the decade.

And in this industry, it’s all about volumes. At current levels, high fixed costs are still impeding profitability. But as sales rise even higher, those variable profits will really build a head of steam.

Let’s do the math. Sales of cars and trucks here in the U.S. look set to rise roughly 10% this year to around 14 million. That figure is still well below historical trend rates as the U.S. consumer remains under duress. Yet as Merrill Lynch recently noted, the “median vehicle age is accelerating rapidly, fueling the need for vehicle replacement.”

Analysts think a slightly firmer economy in 2013 should help sales rise another 10% to around 15.5 million. And as many consumers finally replace their aging vehicles, that figure is expected to rebound all the way to 17 million by 2014 or 2015. That’s 30% higher than the 2011 sales rate of around 12.7 million vehicles. And it’s that 30% change that spells the difference between good and great profits for these high fixed costs firms.

In years past, rising sales largely meant improved results for the Asian auto makers such as Korea’s Hyundai or Japan’s Nissan, as they took market share. Not anymore. The “Big Three” have managed to stabilize market share, and in Ford’s case, market share has actually risen by a percentage point over the last three years.

And Detroit aims even to take market share in the years ahead. Heavy spending on R&D now sets the stage for every current model to be replaced with a new one over the next three years. To put that in perspective, the Big Three launched 37 new vehicles this year, though that figure is expected to be 49 in both the 2013 and 2014 model years.

Perhaps the greatest industry change: Price wars are no longer the industry norm. Auto makers used to resort to $1,000 to $2,000 discounts to move the metal, which is pretty tough when they only made $2,000 to $3,000 per vehicle. A truce of sorts has been declared, and without these incentives, the auto makers are able to generate robust per vehicle profits.

Lastly, it’s only a matter of time before investors realize just how financially strong these companies have become. Ford, for example, is generating so much cash, that even after heavy spending on new products, its cash balance is still expected to rise from $20 billion at the end of 2010 to a projected $30 billion in 2012. As long as industry share prices are depressed and industry cash flows are so strong, you can look for a rising tide of dividend hikes and stock buybacks.

In the second part of this report, "5 Cheap Stocks for an Auto Industry Renaissance," we’ll be focusing on the most appealing bargains in the auto and auto parts sector.

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