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By Jeremy Glaser | 05-03-2011 02:24 PM

Our Top Auto Dealer Picks

With auto sales rebounding, these dealers are best-positioned to take advantage, according to Morningstar's David Whiston.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Wall Street Journal recently named six Morningstar equity analysts, Best on the Street. I'm here today with Dave Whiston. He was named the Best Specialty Retail Analyst, and he covers auto retailers. We're going to talk a little bit about the industry and what some of his favorite names are. Dave, thanks for joining me.

Dave Whiston: Thanks, Jeremy.

Glaser: So let's talk a little bit about what's going right for auto retailers right now. What are some of the factors that are really helping them out and could help them out for rest of the year?

Whiston: Well, I cover the whole auto supply chain and really everyone is benefiting finally from this increase in volume that we're seeing after the severe crash in light-vehicle sales that the U.S. had. We got all the way down to 10.4 million in 2009, which was the worst year on a per capita basis in at least nearly 60 years.

So now since then, in late 2010 and into 2011 you really saw these seasonally adjusted annualized selling rate, or SAAR, creep back up all the way over 13 million, and with that volume you're better able to cover your overhead or get SG&A leveraging of your SG&A expenses.

And on top of that auto dealerships are a great business model. You get a highly lucrative parts-and-service business of near 50% gross profit. And then you get 70% on new and a little bit better on used vehicles, and a 100% gross profit on the financing because that's just a commission. So with volume and with the cost-cutting already done during recession, it's a pretty good time to be an auto dealer right now.

Glaser: What are some of the factors that could be working against the dealers though? Are the events in Japan having an impact, for example?

Whiston: Yeah, really right now it's purely macro headwinds, so things like oil prices, unemployment, although we've seen auto sales come up despite unemployment still being high. For 2011, I think the big wildcard for the auto dealers is the supply chain impact from the Japan earthquake. Obviously, many levels of tragedy to this; my job is to focus on the business side of it. The sad thing from a business point of view is that auto sales were really starting to come back in this country. And then with the earthquake you are going to see that, in particular, in the late second quarter into the third quarter Toyota and Honda and Nissan, particularly Toyota and Honda are not going to have the ability to adequately stock the dealerships with new product.

So the dealers are working right now to compensate by selling more used vehicles. A problem with that is your procurement costs at an auction to buy a late model or nearly new Honda Civic, Toyota Corolla, or whatever it may be, are going to be very expensive, and there are going to be some consumers that will just say, "You know what, I don't want to pay that much for a used car. I want a new car." But the problem is they may not have a new car available. So one of two things will happen, the consumers will either wait altogether to make that purchase, or they'll actually go to a Ford dealer or a Chevy dealer. And I think they'll be pleasantly surprised by the compact and subcompact product that's there.

Glaser: Turning to some individual companies, what do valuation levels look like across a lot of the names in your industry, and are there any that you think are particularly interesting right now?

Whiston: Yes, unfortunately on valuation perspective, the dealers don't look all that attractive to me now. They've had a lot of rallying and they are all 3-star stocks except for AutoNation which is a 2-star stock. Until just last week, though, I was a big fan of Lithia Motors. Unfortunately, though, they did so well in their first quarter results, the stock has gone up about 20%, and it's now just barely below fair value.

But which companies would I like to own at the right price? Almost all of them because they're all great business models. My favorites right now at least from a operating point of view would probably be AutoNation and Lithia. AutoNation is by far the best operator in the industry. Its SG&A as a percentage of gross profit, which is how the dealers look at it, is always the lowest in the industry.

And Lithia is a really interesting story. We've done videos in the past talking about its unique rural-market, small-market focus. I call it the Wal-Mart of auto dealerships really in that it doesn't operate in the same markets that AutoNation, Penske, Sonic, Asbury, Group 1 do. So it has a bit more of a moat aspect to it. All the dealers have a moat, but Lithia's moat is a bit more unique in that. For example, in southern Oregon, which is where they are based, if you want to buy a Chrysler from a non-Lithia dealer, you'd actually have to drive all the way up to the Portland area, which is very prohibitive. And the firm specializes in markets like that. Odessa, Texas, and Alaska are some of its biggest markets, for example, and it just dominates that space because it's the only dealer in a lot of these towns. So that can create some really good opportunities when volumes are going up.

Glaser: Dave, congratulations and thanks so much for talking to me.

Whiston: Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.

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