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My name is Logan Miller. I am the head of European Strategy based out of London. Today I'm pleased to be joined by my colleague, Jim Williamson, who is the head of European autos here at Research and we're going to go around and let us do a deep dive into the European auto sector specifically focused on the OEMs. Clearly, they've been front and center when it comes to some of these global growth durations as well as obviously the near and dear and directly impacted by US tariff situation, trade wars are definitely probably, I would say, the most topical sector still within the European credit markets at this point.
We're coming off of the second quarter earnings results for the sector. It's going to be great to get Jim's insights today. So, Jim, welcome back to the podcast. It's been almost a year since we last did this.
We've got lots of change since up here. Yeah, thanks for having me. I think last time we were relatively negative on the sector and, you know, 12 months on, maybe coming at it from a slightly different angle. So, it'll be good to unpack some of the themes that have happened and, you know, see if we can add some value for clients.
You know, like I mentioned, autos have clearly been kind of front and center this year from a credit risk standpoint, particularly as it relates to another shake up to the status quo from global trade. You know, I recall last year around this time you were pretty cautious on the space and in fact from for most of 2024, but it seems that you've gotten increasingly more constructive on the sector despite tariff Edwin. So, you know, that seems like a very kind of quite non-consensus view to me. Do I have that right?
And can you sort of walk me through your current rationale for the sector? Sure. So, yeah, as you pointed out, you know, this time last year we were kind of very cautious on the sector heading into the second half of 2024. And I think a lot of that was fundamentally driven.
There was a lot of weakness around China. There were things like rising dealer inventories. Consumer was becoming a lot more cautious, but just generally speaking, spreads were very tight in the auto sector as well. So, we had the IG autos index trading pretty much in line with the IG index.
That kind of proved to be the right call. We had a pretty aggressive re-pricing of spreads through the second half of last year. Pretty much every company that we cover ended up cutting their guidance in one way or another. We saw a pretty quick and severe widening of spreads.
So, we came into this year actually with a view that we'd seen the sector de-risk quite a lot because of that widening of spreads. But we had this looming headwinds from the tariff risk where, you know, the swipe spreads being quite cheap when we screened them. It didn't necessarily make sense from a risk-adjusted standpoint to be overweight. So, coming more recently, we've kind of finally pulled the trigger on becoming more constructive.
Obviously, still a lot of tariff-related headlines that are coming through. But I think that now, you know, where we are now relative to even a few months ago, we do have a lot more certainty around what the outlook looks like. And that's kind of helped us in our conviction moving to a more overweight position on the sector. That's, you know, the theme that has definitely been driving markets over the last several months or so.
Obviously, we had the EU US trade deal or framework that was announced less than a month ago. But I think if you had told the market that 15% baseline tariffs was going to be a reality earlier this year, we probably would have seen a pretty major re-pricing of spreads in just risk assets in general, but certainly has not been the case. And at least now we have some sort of potential for tariffs to be sort of in place and what this looks like, what the rates are going to look like. I think that's definitely providing somewhat of a kind of relief to investors just given how much there's the briefs uncertainty there was pre-sort of deal.
But let's stick with it. That's a tariff top, Jim. Can you kind of walk us through your takeaways from the latest trade deal, trade agreement between the EU and the US? Yeah.
So I think there's like, there's two different angles that we can come at the tariff situation. Now, the first is that objectively tariffs are bad for the order sector and they're going to have a pretty financially meaningful impact on these companies. You know, margins are now coming down into the kind of mid-single digit area for most of the companies under our coverage. And that's a long way from the, you know, 10, 11, 12% margins that we had back in 2022, 2023.
So when we look at the guidance for this year, a lot of companies now are incorporating the tariff impacts and we're looking at 5% to 7% say at BMW, 4% to 6% operating margins at Mercedes, 4% to 5% at VW. So without question, I don't think we can just glance over the fact that this has had a material impact on these companies both directly in terms of having to stomach the additional costs of importing vehicles into the US and then some of the more indirect costs around how consumers may be being a little bit more cautious right now given some of the uncertainty. But on the other side, I would say that, you know, when we think about where we are now relative to March or April, we have kind of cut the left hand tail off the distribution in terms of some of the, you know, more severe or punitive outcomes that we could have had. You know, it wasn't long ago, we have 30% tariffs.
We're looking like a very strong possibility in Europe. You know, there was reciprocal tariffs being lined up on both sides of the Atlantic. You know, you only need to look at what's happening in China with, you know, the threats of 100% tariffs to see what the potential, you know, how far the Trump administration is willing to go if, you know, if deals are not negotiated. I think when you look at where we are now relative to April, March, at least we have a number of five impacts where we can actually look at it and say, you know, the margin impact is going to be 100 to 200, 300 basis points, whatever it is.
And there's some certainty for these companies now to look ahead and say, how are we going to change our footprint in terms of manufacturing, how are we going to adjust our pricing, where can we cut costs and things like that. I think from that perspective, the sector potentially is coming out a little bit better than what the worst case scenario is where, but certainly not unscathed. I think what companies are saying about tariffs, you know, are they doing anything or thinking about doing anything in order to circumvent the full impact of these new kind of tariffs will have on margins? Yeah, so I think it depends on, you know, for each company, it depends on your footprint, where you sell vehicles, things like that, as to how impacted you are.
But what we're kind of seeing now is that somewhere in the 100 to 200 basis point areas, becoming kind of a kind of consensus, I would say, if you have maybe a stronger manufacturing footprint in the US, maybe it's closer to 100. And if you're doing a little bit more exporting or importing into the US, sorry, maybe closer to 200. So that's 2025. Now we're starting to see some of the mitigation that they're trying to implement.
So the obvious, obvious first starting point is that we produce, so like a lot of your localization strategy, Volvo, for example, as a side, they're going to localize their most their best selling model in the US. So that's going to help BMW Mercedes even is looking at manufacturing some vehicles in the US. But that's more of a multi-year thing where, you know, if you start now, you can probably have that up and running maybe 2027. So that's going to help longer term, more near term, I think cost cutting is a big one, where it's not necessarily related to tariffs, but it's being driven as a result of now these companies are going out and trying to find additional ways to cut costs.
You know, we saw Volkswagen, for example, you know, 18 months ago, getting some concessions from labor unions around cutting about 35,000 jobs in Germany, reducing the capacity by 750,000, you'd Mercedes reducing their capacity by 100,000 units in Germany, another 200,000 in China. So you do have that, you know, cost cutting can be a bit of a blunt instrument in the auto sector, but it certainly helps to mitigate the impacts of this kind of 100, 200 basis points. And it's something that in many cases, they've already been doing for the last, you know, year or two. And so it's not a case of now starting the cost cutting and then having to wait for that to feed through in the future, it's actually already starting to provide some insulation.
And then the last one is pricing. There's often the talk around tariffs that they're going to be passed directly on to consumers. We very much push back against that narrative at the start and we continue to because when you look at orders where we are, we have a very stretch consumer in terms of average selling prices that have gone up post pandemic, but also interest rates are still historically high. So, you know, I think that's, you know, maybe somewhat of a non consensus view that we don't think that we are passed through.
So from a mitigation standpoint, I think the majority of it's going to come down to how well can you cut costs and equally how much can you manipulate your manufacturing footprint to try and offset some of those more punitive tariffs on your popular models. 100 or 200 basis point impact on margins. Before we kind of get into specific credits that we like and don't like, are there any winners and losers in your eyes or is it still kind of too early to tell, you know, just thinking maybe European OEMs with a large, many US manufacturing presence already, maybe I'll let us sort of work around these tariffs in terms of production. But I know, what do you, how do you think about this, Jim, in terms of who's going to come out sort of more or less on the state?
Yeah. So I think again, it's somewhat comes down to where, what you're comparing to. So if you're comparing to a pre tariff world, it's the same companies that have been highlighted as being exposed that are still going to fill the brunt of the impacts, I guess, companies that don't have any localized manufacturing in the US, Jaguar Land Rover was one that stood out, Porsche's one that stood out, even Volvo car to some extent where, you know, a large chunk of their vehicles, they import. But you know, and names like BMW Mercedes, you know, arguably, okay, position given they have quite big manufacturing footprints.
Again, if we kind of look back at where we are now versus April or March, it may actually be a case where it kind of flips a little bit where, you know, Jaguar Land Rover, for example, you know, when we first ran our numbers on that company, we're probably looking at like a 650 plus base, a percent, 650 basis points of margin compression from the tariffs. For a company that has 8% margins, that's pretty catastrophic. Now, you know, they've got this 10% tariff coming from the EU and 15, sorry, from the UK and 15% coming from the EU. And so, you know, the impact's probably going to be closer to 250 basis points.
So from that perspective, you have, you know, it's a much, much smaller impact than what we would have expected. Likewise, if you think about Mercedes and BMW, there was a lot of talk around the potential for them maybe to get some concessions from the US government because they actually export a lot of vehicles from the US. So maybe there was scope for some quotas or things like that where, you know, for every vehicle you export, you can import one tariff free. The way that these agreements have been reached, they're basically blanket agreements where there's no carve-outs or concessions for any individual companies.
And so I think, when you think about where we came from just a couple of months ago, maybe some of those companies that thought that we're going to get concessions and didn't maybe have to deal with these impacts a little bit more. And some of the companies that maybe had very few mitigation strategies given the lack of localised production, actually the financial impacts are going to be a lot lower than what some of the worst-case outcomes are. All right, so let's kind of just dive into like the, you know, we just wrap up some earnings, obviously, you know, I think overall, you know, just in general European credits have been doing a little bit better than anticipated. You know, how would you characterize Q2 earnings as it's sort of better than feared or worse than expected?
I would say that honestly, it's been somewhat uneventful. Obviously, it's weaker and we've seen, you know, weak emergency over year and things like that. But that doesn't come as any surprise. We've been talking about these tariffs now for the best part of six months and we had expectations already embedded that that was going to be coming.
I think one of the interesting dynamics that's come out of it is that if you kind of just put tariffs to one side for a minute and look at the underlying businesses, that actually was a bit of sequential improvement in operating performance over the second quarter. So if you look at two Q versus one Q, for example, we actually saw from some of the OEMs, we saw a bit of sequential improvement there. So some of that's coming from cost cutting, potentially now with some of these agreements in place, maybe consumers are a little bit more willing to step out and actually make purchases. But whatever it is, I think, again, it helps to at least now that we have the tariff impact quantified and the underlying businesses are, you know, holding up.
And, you know, we can have a little bit more confidence that we're probably approaching levels that are sustainable, I guess, going forward. And it creates a kind of new level playing field of where we can spring back off in terms of China with CFS, where we are from a credit perspective. Can you just kind of quantify the tariff impact a little bit more just for our listeners? Maybe you could talk about individual credits or just sort of broadly speaking, you know, how we're seeing, you know, margins shake out.
And also, I think it's worth comparing current margins of what we're seeing now versus during peak strength of the sector and recent years. Yeah, no, exactly. I think that, you know, as I mentioned, we're kind of in this 100 to 200 basis point. Area now.
And honestly, it's not looking like a mid-single-digit margin is now pretty much becoming the new normal. So, you know, you mentioned prepandant, you know, what we were doing a few years ago, 10, 12, even 14% in some instances was becoming a bit more common. But to us, that was never sustainable. And, you know, we've been pretty consistent in our view that we never expected that these companies were going to be able to generate a double-digit margins through the cycle on a consistent basis.
So I think when you think about autos, the whole Egrale, I guess, has always been this kind of 7 to 9% operating margin is a really solid level that you can generate through the cycle. So when we think about where we are now, we're in this 5 to 7, probably at the moment. So we're probably slightly below. But as I mentioned, we are starting to see a little bit of bottoming out in terms of the negativity around the underlying business.
So now that we start to see, we have to sit around tariffs, those tariffs are getting better than the companies. And then we start to have an opportunity to do some mitigation. Then we're actually probably coming out of this in not too bad shape where, you know, we are definitely below where a lot of these companies are shooting for. But again, we're probably not quite as bad as what the worst case scenarios were if we've gone into a more kind of severe or prolonged trade conflict.
I think the other consideration is that, as I mentioned, this is a bit of a new normal. But one of the things that I've kind of been saying a lot is that even with these margins, we can still generate positive free cash flow. And I think that that's a really important point to kind of consider, particularly in the sense that when you think about investment grade autos, they have extremely strong balance sheets, which is something that we'll probably get to later on in the podcast. But because they have these strong balance sheets, the vast vast majority of their operating performance does not accrue to creditors anyway.
It's all coming in as free cash flow. And it's basically getting passed straight through to shareholders and dividends and buybacks and things like that. In a way, as a creditor, I think, in some of these bigger cash structures that have the balance sheet strengths, the thing you're more concerned about is, can we continue to look at the balance sheet as a pillar of strength? And I think so long as you're in a position where you can generate positive free cash flow consistently, then I think that goes a long way to ensuring that over intermediate term or medium term time horizons that you'll be actually remain in pretty good shape from a credit perspective.
Describe what companies are doing and being able to maintain relatively stable margins. Are they planning to sort of just continue to eat the costs or are they finding other ways of work run? Yeah. So I mean, ultimately you have two options, right?
You can try and pass it through or you can eat the cost. I kind of alluded to it earlier, but we're definitely in the camp that they're going to have to eat the vast majority of the cost. And the obvious one is the pricing element that I touched on already, which is, you know, there's just not much scope out there right now for these OEMs to be able to push pricing. And I can put some numbers behind it.
So for example, like new vehicle prices are up about 30 to 35% versus pre-pandemic levels right now. So like the cost of purchasing a new car and the average monthly payment on a vehicle that's bought on finance, which is the vast majority of vehicles globally now, is now at about $750 US dollars up from about 550 pre-pandemic. So that's a pretty potent combination for consumers where you already have, you know, we haven't got wage growth at the same levels as what we have seen in the past. We already have the high sticker prices of the vehicles and we have the high financing costs to try and service that debt.
So we just don't really buy into this argument that, you know, they're going to pass these things straight on. I think you're hearing from, you know, anecdotally from companies saying things like, you know, Ford saying, oh, we're going to, we're going to wait and see what our competitors do or we're running a promotion for the next two or three months to get rid of pre-tariff inventory, things like that. To me, that's kind of semantics in a way. I think the takeaway is that they don't have the pricing power and it's, you know, they're acting like they're trying to do consumers a favor here, but I think it's just kind of more emblematic of the lack of pricing power given that we saw this massive step change in terms of new vehicle prices over the last few years.
So yeah, I think they're going to have to eat their costs and then it comes back to some of those other factors in terms of how good are you at cutting costs or doing other things to try and offset it organically. All right. So it's the last kind of question and talk around fundamentals at least for now. So Jim, you know, any concerns about rating his downgrades if, you know, a turnaround story for the sector doesn't start to build and we're sort of in this prolonged period of weak demand and sort of like cutting any margins.
Yeah. I mean, it's a great question and it's one we get a lot actually. I think there's also a little bit of nuance that can sit here as well. There's definitely some structurally challenged companies out there.
So like in investment grade space, Stellantis is a great example. They had multiple upgrades, you know, since the pandemic where things were going really well, operating performance was going to strength the strength they had the strong balance sheet, you know, but that's kind of been replaced now by, you know, abysmal operating performance. And, you know, to be completely honest, that it's looking more and more like a high-year company, you know, with every passing day. So I think one thing is that it'll be a very slow process and one of the things that we have in the auto sector is because of the strength of the balance sheet, it does afford the grading agencies quite a lot of runway to allow things to play out before they make big decisions, particularly on downgrading companies like the crossover names down to high yield.
So, you know, I think when you look at a name like Stellantis, we definitely see downgrade risk and that's something that, you know, we've spoken about and we'll continue to monitor. I think when it comes to other investment grade names, like the big three Germans, the WBNW Mercedes, I think a little bit less convinced that there's going to be downgrades. And I definitely don't think it's going to be at the pace where it's like a tradable catalyst. As I mentioned, the balance sheets are just very, very strong and they're very large, well capitalized.
They have these very profitable financial services businesses. So, you know, BMW Mercedes, for example, got put on negative outlook last week or the week before, but you read through the report and you really get the sense that, you know, this is going to be a very much a slow burn. The rating agencies are talking about over extended time periods if they can't recover operating metrics within certain parameters, but it's certainly not a case of, you know, if we can't do it by next month, that they're going to be pulling the trigger on some of these things. I think in the high yield space, it's a different story and we've seen, you know, a lot more downgrades already in the last 12 months or so, certainly there's a lot more bifurcation in that space where you know balance sheets are not so strong and things like that.
I think in that space, it's a little bit different, but within the investment grade space more specifically, I think actually, you know, we probably lean more towards living less risk of downgrade than more. Yeah, I guess by definition, high yield copies are, you know, leveraged to their cash flows and earnings, and they've been a bit more, you know, kind of weaker in terms of the ratings ringside. Let's move on, Jim, so you always talk about positioning, you know, whether it's going to broadly speaking across, you know, European markets or within autos in particular, but I know you've been sort of a standout compared to the rest of the analyst team and London, but you know, let's kind of dive into your upgrade on European autos as a whole to an overweight and from a marketweight or neutral back in mid-July. You know, did this rec change imply that you think the worst is over?
Or are you going to be from a relative perspective? Yeah, absolutely. I do enjoy talking about this part. So as I, you know, I've kind of mentioned it already, but I would just say it again just to be a crystal clear.
I don't want to be come across blaseous to the fundamental challenges that are facing the sector. I think, you know, there's no question, you know, that directionally operating metrics have deteriorated both margins and free cash flow and that definitely, you know, reduces your, I guess margin of safety when you think about like how these companies can navigate downturns in the future. But I do also think from a relative values, you know, from relative value perspective, there are actually a lot of pillars of support that you can look to right now that kind of all come together to make actually quite a compelling story. And so I'll just run through a couple of them.
The first I would say is that operating performance is good enough. I spoke about it a little bit earlier, but you know, margins are definitely weaker, but they're good enough to still continue to positive generate positive free cash flow for most of these companies. And so that importantly is good enough to help protect the balance sheets. The second is that the balance sheets are very strong.
And I know that that's something that's, you know, generally been the case for the last 15 years. So you have to be a little bit careful about, you know, just always saying balance sheets are strong therefore it's a buy. But again, if I can just put some numbers behind it, you know, we're in much stronger and a much better starting point than we were pre pandemic, for example. So if we aggregate up, you know, BMW, Mercedes and VW, who make up about 65% of the ID index, they have an industrial net cash position now of about 67 billion, which was almost twice as strong as the 36 billion in 2019.
If we look at cash on the balance sheet, you know, as a percentage of revenues, it's sitting at about 17%, which is up from about 15% pre pandemic. And so I think again, from like as a starting point, I think you're just coming into this from a lot stronger position than what we had, you know, five, six, seven years ago. The third thing is that duration is relatively short in the sector. You know, it's one of the shortest duration sectors in the index.
But a lot of that is because of the, they used the bond market to finance the capital financing businesses. And you know, you're struggling to find what many bonds longer than say 10 years. And it's more about kind of four to seven years, I say the sweet spot in the order of sector. And so when you marry that up with, you know, when I say that, you know, offering performance is good enough, you know, free cash for that's, you know, positive but not phenomenal balance sheets that are, you know, in very, very good shape.
You know, not only do you need, if you're going to be negative on the story, not only do you need balance sheets for credit quality to deteriorate, you actually need it to happen very quickly because of the very short duration profile. So if you think about this from like, if we're talking about this from an equity perspective and looking at these equity stories, I would agree that there are a lot of these are structurally challenged names from that perspective. If we look out 10, 20, 30 years, we'll be here, you know, we'll have to wait and see. But thankfully for us as credit investors, we're not necessarily concerned with the company's going to be here in 30 years or not.
We're just worried about whether we're going to be getting paid back and now, you know, we're going to be looking at this for the seven year thing. So maybe we're looking at say 15 year time horizon. And so I think that there's that aspect. The fourth is that like spreads are historically white levels.
So right now we're about 15 basis points wide at the index. And what's very interesting to me is that we've actually seen spreads tighten about five basis points to the index year to date. I think Logan mentioned that at the top of the podcast, you know, that's, if you've gone into this year and we'd said, okay, you know, we're going to get all these tariff news, all those are going to be right in the, in the thick of it, you know, we're going to see margins deteriorating, free cash for profiles declining, all these things and spreads are actually tighter. I think, you know, people would have probably laughed you out of the room.
And so some people would look at that and say, oh, it's a sign of complacency. I would actually say that, you know, we probably need to zoom out a little bit more and we need to look at that massive re-pricing of spreads that we saw the second half of last year where we actually de-risked the sector a lot coming into this year. And so I think that sort of emblematic of this view that, you know, we have actually seen every pricing that's sufficient to, to a bacon, a lot of the negativity that we're seeing from, from these tariffs, particularly now that we can quantify them and we can say, you know, we can make a pretty good argument around the compensation for the risks, I guess. And the last one is, is like a, is more around sentiment and positioning.
It's pretty horrible, I would say, generally speaking, when we talk to our clients, you know, a lot of the investors we speak to are either structurally underweight or have just kind of given up altogether and they're just not even allocating to the sector because, and I think it's an easy one to get on board with, right? You can say, okay, I'm either short because there's all these near-term risks around things like tariffs, around declining operating performance, things like that, or you can say, you know, structurally, you know, I don't like the sector because of risks from China, you know, all these other aspects where you may be the long-term structural story is not super, super solid. So I think from that perspective, when you marry that up also with the things I mentioned about, you know, balance sheets, duration, short duration, spread to the wide, and the fact that investors, you know, it's a pretty hated area of the market, generally speaking, I think that gives you a massive tailwind for like risk reward asymmetry where the negativity of the news that you'd need to see to see spreads reprice meaningfully wider from current levels is, you know, the hurdle is very, very high, I would argue. I think you're overweight, stomachs, a lot of sense.
Plus, it's not to mention, you know, you've had quite a bit of steepening of the curve and so I think, you know, just from sort of all-in-cost of financing yourself, you mentioned auto is tend to bar short in any ways. That's certainly helpful. We've had some of the interest burn at least from that perspective. We made our way around the auto space.
We've talked about tariffs. We talked about the impact of margins. We talked about earnings. And then we've gone through sort of positioning, but let's kind of, you know, come full circle and for credit investors, talk about your picks and pans across the space.
First, I guess, before we do that, I guess, can you just walk us real quickly through how you distinguish between issuers and your coverage when it comes to single name recommendations, you know, for instance BMW versus Mercedes? What are you looking for in the credits that you like the most? So I would say in the investment grade space right now, we're kind of looking at recommendations more from a portfolio construction view, I guess. And by that, I mean, because of our more constructive view on the sector, we actually kind of fade by going down to quality a little bit.
And the reason for that is because when we think about the factors that I discussed above, within that investment grade realm, some of the wider trading names actually kind of benefit from those aspects almost to the same extent as the higher quality names. So, you know, when I talk about things like margins being good enough, well, VW margins are actually not too dissimilar from BMW and Mercedes. When I talk about the balance sheet being very strong, you know, VW arguably has a balance sheet as strong if not stronger than those two. You know, when we talk about, and then when you talk about spreads, VW spreads are another kind of 40, 50 basis points wide of BMW and Mercedes as well.
So I think that when we think about how we want to position and we get your kind of best bang for buck, I guess, in the space, then I think you get better compensation from shifting down a little bit. And, you know, just to be clear, like, you know, we don't think that there's always just, there's always a good idea just to reach down and quality blindly. The land says it's a name that trades very wide that we don't like, we have it underway on, and we think that, you know, fundamentally, there's a lot of reasons to be very cautious on that name. Equally, if we look into high yield, you know, we have sell recommendations on some, you know, wide trading names as well.
So I think that, you know, just to kind of clarify that aspect, but I do think in the investment grade space, the balance sheet strength is a little bit underrated, I guess, we're under appreciated to some extent. And so given our constructive view more broadly, I think it makes sense to be overweight, VW, particularly relative to the German BMW and Mercedes. All right. So if you have your obvious candidate, what about in high yield?
Yeah. So in high yield, I think for us, it's all about capital structure. You know, there isn't the same balance sheet strength that we see in investment grade where you can be, you know, where you can kind of have this more portfolio view on it, I guess, where you can kind of decide to move up or down quality or in our out-and-duration because you have very idiosyncratic stories, you know, names like Antiline and ZF, where, you know, we have been talking for, you know, probably the best part of two years about the unsustainability of those capital structures, you know, we're seeing severe severe re-pricing of those bottoms. You know, they were both names that arguably looked like compelling names to own, you know, but we managed to kind of avoid the pitfalls of being involved in some of these names that don't have the sustainable capital structure.
So for us in high yield, it's less about trying to find, you know, necessarily, or whose margins are improving, which story necessarily is improving the most, but it's like, who can survive for now in the high yield space? It's about being in names where you have the capital structure where, you know, if in 12, 18 months, two years, we're still kind of floating along the bottom of the cycle, who's still going to be around and isn't depending on that. So in the high yield space, for us, that's names like Volvo car, you know, we're operating performance as well. So it's a big week, but has like an investment grade level balance sheet, Vallejo, which has much, much lower leverage than it's peers, and is also kind of improving.
If you want to go all the way down into like single B land, be quite like, like, Ed LaPelza, where you can get, you know, a double digit yield on a company where, you know, it's proven that it can handle a nine or 10% coupon for the last two years. And so I think that, yeah, we've put a large amount of weight on that and we'll probably continue to. All right. And then obviously, you know, you mentioned as credit investors, you're really just kind of focused more so on whether or not you're going to get paid back rather than the sort of terminal value of the company.
Who are you most concerned about in auto space, fundamentally? Yeah. So I think, so we have underweights on BMW Mercedes, but I would say, you know, that's those are not names that we're necessarily concerned about fundamentally. Those are more portfolio, portfolio construction underweights, I would say.
So, I mentioned as a name that we really think it's going to be difficult for them over the next, you know, two, three, five years, you know, like I said, they basically look like a high-year company now, you know, less than 1% operating margins, you know, they've been through tens of billions of free cash flow over the last 18 months or so. And it's going to be a long and arduous journey for them, I think, to close the gap back to peers. You know, they've lost a lot of market share. They market share in the US has basically halved over the last, you know, couple of years.
And that's extremely, extremely difficult to get back. And so, you know, what you have, you know, when you have auto companies that are as big as a philanthropist, you don't just roll out one or two new models and expect that it's going to kind of turn the fortunes of the company around overnight. It's very much, you know, you've got product cycles in the auto space that can last anywhere from like six to eight years. You know, they have tens of not hundreds of different models across, you know, a large number of brands.
And so, you know, when you find yourself in these really challenging positions where you have, you know, market share, that's dwindling, you have a product portfolio that's, you know, not resonating with consumers. And just like a sub-par performance and generally, it does take a long time to rectify that and it can be extremely costly as well. How do you, you know, do, how do you win that market share back? Do you discount?
Do you know, or do you kind of sit on the sidelines and say, you know, six or seven percent market share is good enough for us? Well, that's going to be a decision they're going to need to make. But in the meantime, you know, these margins are very, very weak. This free cash flow profile is very, very weak.
It's a currently rated mid-triple B, but you know, I think almost certainly we'll end up getting downgraded to the logical B and I think, you know, I would certainly not rule out this company ending up back in high yield at some, at some stage over maybe the next two or three years of, you know, absent kind of some miraculous recovery, which looks, you know, very unlikely. Right. So let's wrap up the podcast with a final topic or question. And that is what could go wrong for the sector or what are the risks that you're most paying attention to right now?
Yeah. So I think a lot of our thesis, I guess, is predicated on the view that, you know, think that we can just kind of bump along the bottom of the cycle and that, you know, when I say operating performance is good enough, you know, that is whether or not that's going to be good enough, I guess. So, you know, when you think about like the margin of safety, when we came from the double digit operating margins two or three years ago, yes, we've had a whole lot of issues that we've had to deal with that have taken margins from 10 percent to 5 percent and it's been painful for a lot of these companies. But that's now taken, you know, even at these current levels, we still are in a position, you know, to generate the positive free cash flow and all these things that I've spoken about.
The risk, I guess, is that, you know, you don't, going from 5 percent to 0 percent, it becomes incrementally a lot more painful for these companies. And given how capital intensive they are and things like that, the amount of operating leverage that you have embedded in these businesses, you know, things as they get weaker and start to kind of snowball very quickly in terms of the financial impact. So, you know, if for example, we start to see economic growth start to roll over some of the more less constructive people around, you know, the long and variable legs of tariffs or the long and variable legs of central banking policy, which is rates are still very high, things like that. You know, I think those are still meaningful risks on the downside.
And so I think, you know, if you are in the camp that, you know, we're going to see this another significant leg lower in terms of the economic outlook, then maybe there are some reasons to be cautious. But I think our base case, and I don't know if you have anything to add on this slogan, but like, you know, we think that things are probably good enough to kind of bump along. We do have a few levers coming from things like the fiscal stimulus in Europe and aspects like that, which, you know, when we look out one, two, three years, I think you can make a decent case that while it's not going to be gangbusters in terms of like this, you know, massive recovery or, you know, we're going to go through a Goldilocks period. I don't think, given West Bridge trade, you necessarily need that.
But maybe I'll eat the last thought, see you on it. No, I think those are all good points. I mean, I would also mention there's been some pretty big surprise this year when it comes to, you know, fiscal stimulus kind of saving off an economic downturn, particularly out of Germany, but I'd also mention just the fact that we've seen very strong flows into European credits. So that capital flow tends to sort of help borrowers maintain pretty healthy balance sheets.
Interest rates have been coming down and you're up, certainly paves the way for at least, you know, a more benign economic outlook compared to some of the volatility that we're seeing in terms of US policy going forward, what that's going to all to be mean for US consumption. But yeah, I think this is obviously a lot of questions to left. I mean, I think you've really framed out your argument for auto is pretty concisely and you've gone, you know, kind of full circle here. So people will wrap it up here today.
Jim, thank you so much for coming back on the podcast. Hopefully we don't have to wait another year to do it again, but certainly it's been an interesting great discussion so far. So thanks for coming on. Yeah, thanks for having me.
I'm sure there'll be lots more things to talk about next time. Good to say to slayer, I'll face references corresponding to the date of this recording. This podcast should not be copied. It should be that for reproducing whole warning part and I've got a site to North Italy.
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