Why This Automotive Industry Problem Might Not Be as Bad as Investors May Think

Source: Jericho, via Wikimedia Commons

What a great time to be a Detroit automaker: Executives probably feel like the only thing limiting them from grabbing more cash is the size of their hands.

Ford Motor Company and General Motors are selling full-size trucks and SUVs left and right, which is helping them churn out huge profits in 2015. Expect each of them to post near-record profits for the year. Ford's and GM's pre-tax margins during the third quarter hit 11.3% and 11.8%, respectively, in North America, which is very strong in the capital-intensive automotive industry.

What's the catch? If you've noticed recent headlines, automakers are increasing the amount of incentives and discounts used to sell vehicles. The worry is that automakers are showing no sign of slowing down on incentive spending, and it could fuel a profit-destroying incentive war. Nobody wants that, especially investors.

Let's take a look at the figures and see if there's an explanation here.

What's the big deal?TrueCar estimated that incentive spending grew 14.1% during October in the U.S. auto industry. The problem was that, in October, the average transaction price of vehicles sold remained flat at $32,529 compared to last year's October. Throughout much of 2015, average transaction prices had increased with incentive spending, essentially nullifying incentive-spending increases.

More specifically, average incentive spending per vehicle grew $383, to a total of $3,104; that increase pushed the ratio of incentive spending to average transaction prices up to 9.5%, which was much higher than last October's 8.4%. Analysts believe that, once that incentive-to-ATP ratio hits 10% or higher, it will begin eroding the healthy profit margins the U.S. automotive industry is enjoying right now.

To make the incentive-spending scenario seem worse than it might actually be, it appears that major automakers are only gearing up for further incentive spending and discounting heading into the important holiday season.

General Motors is doing some promotions of its own, with its highest-selling brand in the U.S., Chevrolet, kicking off a "Black Friday All Month Long" sale, offering some pretty significant discounts on 2015 models. One example is the 2015 Cruze LT, which is being discounted by a little more than $4,000, or about 20% off, according to Automotive News.

Ford kicked off its "Friends & Neighbors" promotion, which will pre-set a price within about $200 of the dealership invoice price for vehicles. However, while that sounds like it would increase incentive spending and discounts, Mark LaNeve, Ford's vice president of U.S. marketing, sales and service, told analysts on the company's third-quarter conference call that the promotion wouldn't raise the level of incentive spending. Many remain skeptical that the promotion won't ultimately hurt margins, but we'll have to see how that plays out.

While the rise in incentive spending during October isn't ideal, the situation might look worse than it really is. Here's why.

Big-ticket items are selling well The fact is that vehicles with higher transaction prices -- full-size trucks compared to compact cars, for example -- also carry higher incentives and discounts. Despite those higher incentive totals, margins on full-size trucks and large SUVs are among the best in the industry. Consider that 620,000 cars were sold in the U.S. during October, which was a 4.1% increase compared to last year's October.

However, sales of light-duty trucks -- which includes crossovers, minivans, SUVs, and trucks -- were up a staggering 21.9% compared to last year's October. For context, sales of light trucks are up 12.7% year to date compared to 2014, suggesting that sales of vehicles with high incentives surged last month.

Part of the reason we're seeing an increase in incentives is simply because vehicles with higher incentive totals are red-hot selling items right now. What investors will want to watch going forward is whether or not average transaction prices resume moving higher -- that was the real issue last month -- which will nullify increases in incentives. Or if major automakers cool down their incentive spending after the holiday season before the ratio of incentives to ATPs reaches 10%.

This is certainly a development for investors to watch heading into 2016, as it will have a direct impact on automakers' bottom lines in the profit-churning North American region.

The article Why This Automotive Industry Problem Might Not Be as Bad as Investors May Think originally appeared on Fool.com.

Daniel Miller owns shares of, and The Motley Fool recommends,Ford, General Motors, and TrueCar. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.