Beyond Cash for Clunkers

The U.S. government's Car Allowance Rebate System (CARS), more commonly known as "cash for clunkers," has brought a lot of attention to the auto dealer sector. With dealer stocks having had a huge run in 2009, we thought this was a good opportunity to discuss CARS' impact on the auto industry, why we think the program is overhyped, and where the sector is going following one of the worst sales declines in history.

CARS Sales: Incremental or Pull-Forward?
First, let's look at the current impact of the CARS program. The $3 billion stimulus has been a success in that it has dramatically increased light-vehicle sales. According to Automotive News, the July seasonally adjusted annualized sales rate, or SAAR, increased to 11.1 million vehicles. No prior month this year even reached 10.0 million in annualized sales, so we think the program has brought consumers into showrooms who otherwise would not have bought a vehicle. The risk, of course, is that this incremental demand eventually turns into pull-forward demand. In other words, the stimulus could pull 2010 sales into 2009.

So far, industry executives do not think this risk is materializing. In a recent CNBC interview,  AutoNation (AN) CEO Mike Jackson said the demand AutoNation stores are seeing is incremental; without CARS, these customers would not have bought a vehicle at all and would have just kept driving their clunkers. Toyota Motor Sales USA President and COO Jim Lentz made similar comments in Automotive News, saying "we're confident we've gained incremental new business for Toyota and the industry."

Current CARS sales may be incremental in the short run, as customers could have just continued to drive their older vehicles, but those vehicle would eventually need to be replaced, with or without a stimulus. Thus, assuming consumer confidence does not dramatically improve next year, we suspect stimulus is taking more from 2010 than people think. In this way, government stimulus is really just treating the symptom, not the disease, and we do not want to see another extension once the $3 billion is used up. Once stimulus programs end in the U.S., Asia, and Europe, there could be another large drop in sales if consumer confidence remains weak.

New Dynamic in Used Car Pricing 
Another impact of the CARS program has been its effect on used vehicle pricing. Normally, incentives on new vehicles drive used vehicle prices down. According to Manheim Consulting chief economist Tom Webb, every $1,000 in new vehicle incentives decreases used vehicle prices by $750. However, new vehicle inventories were low even before CARS started on July 24, which has helped to support higher used vehicle prices. Furthermore, CARS has actually increased demand for used vehicles. Many consumers went to dealerships intending to participate in CARS but found out their trade-in was ineligible, so they decided to look for a used vehicle on the same dealer's lot.

Dealers are thus bidding up auction prices as they acquire more used vehicles to sell to customers who cannot trade in their clunkers. According to Manheim, the Manheim Used Vehicle Value Index for July was at its highest level since September 2007. One of the attractive aspects of a dealer's business model is that it can make money on used and new vehicles, in addition to lucrative margins on service and financing. More vehicles sold means more cash in the door to cover overhead and more highly profitable service revenue.

The loser from the increased pricing of used vehicles is likely to be  CarMax (KMX) because an increase in traffic to traditional dealerships likely means that these customers are not entering a CarMax store. We will not know for sure if CarMax's store traffic is being negatively impacted until the firm's next quarterly earnings release, scheduled for Sept. 22. Regardless of the impact, we still think CarMax is the best used vehicle retailer around and consider any lost foot-traffic from the CARS program to be nothing more than a short-term drag on profitability.

Imports Drive Ahead on CARS
A final noteworthy point about the CARS program is what vehicles are being traded-in and purchased. An Aug. 17 Automotive News article listed the top-10 trade-in models as well as the top-10 new vehicles purchased. All 10 trade-ins are Detroit Three models while only two new vehicles are Detroit Three (Ford Focus and Ford Escape). This information suggests that the U.S. government's stimulus may have the unintended consequence of increasing market share for Asian automakers, which made up all of the eight other slots.

We do not blame the government for this result. Rather, we believe it is a reflection that the market strongly prefers import brands for smaller, fuel efficient cars. One should not be surprised by this trend given that high union labor costs, combined with absurd U.S. fuel efficiency laws in place since the 1970s, have forced American automakers to neglect the car market in order to focus on the more profitable light-truck segment.

For example,  Ford's (F) 2008 U.S. unit sales mix was 36.6% car while  Toyota's (TM) was 61.2%. The total car mix for the U.S. last year was 53.2%, 54.3% year-to-date through July, and 57.9% in just July. More mix shifting to platforms where the imports are stronger is not good news for Detroit. With the Detroit Three's U.S. sales mix skewed away from cars for so long, it is not surprising to see the imports winning share on the CARS program.

 

Outlook for Auto Dealers
We think the dealer sector is the best business in the automotive supply chain. The firms do not have large fixed cost bases since they are not manufacturers, they have no burdensome retiree expenses, and the large public dealers are not dependent on the health of one brand.

The dealers enjoy mid- to high-single-digit gross margins on new and used vehicles and 100% margin on financing and insurance. The best part of the business model is the parts and service operations. Many customers bring their vehicle to the dealer for servicing because the vehicle is either under warranty or because the dealer is close to home and has the factory parts and expertise to service the vehicle.

Once vehicle owners know a dealer, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle and comparison-shopping for repair work is very time consuming since the customer has to bring the vehicle to each shop to get a quote. These logistics create inelasticity of demand, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. AutoNation's parts and service made up 17.4% of 2008 revenue but contributed 45% of the firm's gross profit. For the dealers we cover, parts and service gross margin in 2008 ranged between 43.5% and 55.6%.

Despite these great business models, we think there are currently no attractive valuations in the dealer space. The time to buy dealer stocks was when no one wanted them back in late 2008 and early 2009. As of mid-August, stocks such as AutoNation,  Asbury Automotive (ABG),  Group 1 Automotive (GPI),  Lithia Motors (LAD),  Penske Automotive (PAG), and  Sonic Automotive (SAH) have increased from their 52-week lows by 5 to 18 times, depending on the company.

Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth going forward since these firms can be the most flexible in changing brand mix. The U.S. dealer industry is very fragmented and is consolidating more and more in favor of dealers who sell over 750 new vehicles a year. According to the National Automobile Dealers Association (NADA), as of Jan. 1, 2008, the number of dealers that sell over 750 new vehicles a year has increased 11.6% since the beginning of 1988, while the number that sell up to 149 vehicles has declined 52.4%.

AutoNation is the country's largest dealer group, and we estimate that it sold only 0.8% of all new and used vehicles in the U.S. last year. We also think that AutoNation is the best operator in our dealer coverage universe as its scale and focus on continuous improvement in overhead costs enable it to almost always have the highest operating margin of the dealers listed above.

Penske Automotive Group deserves some attention for its intended acquisition of the Saturn brand from Motors Liquidation Company  (Old GM). This deal is expected to close by the end of September and consists of Penske Automotive buying the brand and likely some parts and a few vehicles. Penske will neither buy Saturn plants nor be a vehicle manufacturer. It also does not intend to buy any Saturn dealers. Penske intends to offer current Saturn dealers a new franchise agreement to sell vehicles that Penske will have exclusive U.S. distribution rights to under the Saturn name. The most likely automakers who may choose to brand a vehicle as a Saturn are Peugeot, Renault, or a Chinese or Indian automaker. If a Saturn dealer chooses not to sign an agreement with Penske Automotive, then that dealer would lose its new vehicle franchise rights and either go out of business or become a used vehicle retailer. Like all of our dealer valuations right now, we believe we have the upside to Penske's earnings already factored into our fair value estimate.

Effects of the CARS program are likely to be short lived, and we think people should look past its hype and catchy name and instead focus on fundamentals. What will separate the strong dealers from the weak is balance sheet strength, brand mix, and store geography.

For the most part, the publicly traded dealers do very well with these criteria, with AutoNation being the best operator. Sonic has some issues with its balance sheet but is otherwise a great firm. Lithia has carved out a very lucrative niche in smaller markets, but its heavy mix toward Chrysler means it needs Chrysler's alliance with Fiat to succeed.

Regardless of how strong a dealer is, it will not see large increases in earnings until it can sell more new vehicles. Recent events such as the return of GMAC to leasing and slowing unemployment are good signs, but we think a return to normative industry sales of 14-16 million units is more than a couple of quarters away.