Don't Believe the Tariff Hype for the Big 3 Automakers

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Shares of domestic automakers General Motors (NYSE: GM), Ford Motor (NYSE: F), and Fiat Chrysler (NYSE: FCAU) plunged last week after President Trump unexpectedly declared that the U.S. would impose tariffs on Mexico as part of a strategy to combat a surge in migrants entering the United States across the southern border.

The wipeout for these auto stocks was understandable, as all three import lots of components and completed vehicles from Mexico to the U.S. That said, many analysts and investors appear to be overreacting to the threat of tariffs. GM, Ford, and Fiat Chrysler have meaningful opportunities to mitigate the potential impact of tariffs. Additionally, improving commodity cost trends should help offset any tariff headwind over the next several quarters.

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Tariffs on Mexican imports could be coming soon

Last Thursday, the Trump administration announced that the U.S. will impose a 5% tariff on Mexican imports beginning on June 10. The tariffs are set to increase to 10% on July 1, 15% on Aug. 1, and 20% on Sept. 1, before finally plateauing at 25% on Oct. 1. "Tariffs will permanently remain at the 25 percent level unless and until Mexico substantially stops the illegal inflow of aliens coming through its territory," according to an official White House statement.

This tariff threat came out of the blue, particularly because the Trump administration had just started the process of sending the new USMCA free trade agreement to Congress for ratification.

Even a 5% tariff on imports from Mexico could have a significant impact on U.S. automakers. While estimates vary, GM and Fiat Chrysler appear to get about a quarter of the content for their vehicles sold domestically from Mexico. Ford is in slightly better shape, according to Deutsche Bank analysts, with 17% imported Mexican content.

Meanwhile, a 25% tariff rate could cause huge disruption. Deutsche Bank estimates that absorbing a 25% tariff on all imports from Mexico would have a crippling annual bottom-line impact of $6.3 billion for GM, $4.8 billion for Fiat Chrysler, and $3.3 billion for Ford.

Automakers can adjust

There may be some value in calculating the notional impact of various tariff rates on automakers' profits assuming they make no adjustments, just to get an understanding of how much they would need to respond. But in reality, GM, Ford, and Fiat Chrysler can use a combination of supply chain changes, price increases, and production cuts to dramatically reduce the impact of tariffs on their profitability.

For example, some of the vehicles GM has been assembling in Mexico include the subcompact Chevy Sonic sedan and Chevy Trax crossover, as well as the Chevy Cruze compact car. GM is already discontinuing the Cruze in North America. Meanwhile, paying a 25% tariff on the Sonic and Trax would surely be a money-losing proposition. Instead, the company could encourage dealers to push customers toward the Chevy Spark subcompact car and the Buick Encore subcompact crossover, neither of which are built in Mexico.

The proposed tariffs would also hit GM's new Chevy Blazer crossover. While that's unfortunate, GM would probably just raise prices to offset part of the tariff headwind for that model, recognizing that it offers customers lots of alternatives in the crossover market.

Finally, GM does build a substantial number of full-size trucks in Mexico. Yet it also builds them at two facilities in the U.S. GM could potentially sell a substantial number of the Mexican-built trucks in Canada. It also has already announced a $24 million investment to boost full-size truck production in Fort Wayne, Ind. By boosting U.S. truck production, trimming Mexican truck production, and shipping many of the Mexico-built trucks to Canada, GM could dramatically reduce its tariff bill. Relatively modest price increases could cover the extra costs.

Fiat Chrysler and Ford have similar flexibility to lessen their tariff bills by maximizing domestic sales of U.S.-built vehicles with relatively little Mexican content. And since few, if any, automakers would be able to avoid the proposed tariffs entirely, it shouldn't be hard to push through price increases to offset tariff costs.

Commodity cost tailwinds will offset tariff pressures as well

Another factor worth mentioning is that soaring commodity costs have pressured automakers' profits since the beginning of 2018. However, commodity prices have moderated significantly in recent months.

Benchmark prices of steel for delivery in the U.S. Midwest have fallen about 30% since peaking last July. Most of that decline has come in the past three months. Aluminum prices have plunged more than 20% over the past year. Even the price of palladium -- a rare-earth mineral used in catalytic converters -- has declined more than 10% over the past three months, after tripling between early 2016 and early 2019.

Automakers often have long-term supply agreements and hedges in place for the most important commodities they use. As a result, the recent decline in commodity prices may not filter through to the bottom line at GM, Ford, and Fiat Chrysler immediately. But over time, the automakers should be able to capture substantial savings relative to what they have been paying recently.

Commodity cost savings will thus blunt the need for price increases to offset tariff costs. That's just one more reason why GM, Ford, and Fiat Chrysler are in much better position to weather potential tariffs on Mexican imports than many investors seem to believe.

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Adam Levine-Weinberg owns shares of Ford and General Motors. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.