Bet on the Auto Dealer

Cheap gas, diverse product line and cyclical demand should drive sales for the nation’s largest car dealer.

By most accounts the auto industry should be loving 2015. There has been pent up demand as the average age of cars on the road climbed to 11.2 years in the wake of the financial crisis. Sales should continue to trend higher.

  • Unemployment is near seven year lows. Wages are slowly creeping higher.
  • Gasoline is at seven years lows and likely to stay low.
  • Interest rates are near record lows and lending terms have loosened.
  • New models are chock full of technology that have consumers excited about “smart” cars.
  • Company balance sheets are strong courtesy of restructuring (pension/labor contracts) following the financial crisis.
  • Technology has reduced production costs boosting profit margins to the highest level in over a decade high.
  • The cherry on top being 43% of the vehicles sold during the past 52-weeks were in the profitable Pickup and SUV categories. That number is projected to trend to 54% over the next year.

These items have combined to spur auto sales past 18 million annual units last seen 2007 and the manufacturers cash flow profitability. Truly the glory days for the auto industry.

So why have shares of Ford (F) and General Motors (GM) performed so poorly, down 13.5% and 17.8% respectively for the year to date?

  • Weak sales in both Europe and the more recently the sharp slowdown in China. They derive 50% of revenue and 85% of growth from foreign markets. Slower growth and stronger dollar hurts.
  • Recall related costs including litigation and ill will.
  • The trend towards ride sharing. Millennials have an app culture. Not a car culture.
  • Oh, did I forget to mention the new clouding forming in the shape of Volkswagen’s emissions fraud that’s likely to hang over other makers.

The legacy makers ain’t exactly glamorous growth investment vehicles. But I also don’t want to bet on some pie in the sky high valuation stuff like Tesla (TSLA), or Mobileye (MBLY). Where should we turn?

Play the Dealer

The best way to play the cyclical trend of car sales is through AutoNation (AN), the largest dealer in the U.S. Its business model is steady and insulating from the above push and pull. Extracts a steady profit from a stable service business.

  • It sells all brands and models, new and used which diffuses exposure. Insulated from recall, currency and other external events.
  • Still has room to expand in a fragmented market.
  • Reaps higher margins on the increased sales of Pickups and SUVs

Essentially Autonation will benefit from all of the positives listed above while remaining insulated from the list of negatives.

Technically the chart is somewhat neutral but the $58 level offers decent support.

AN Chart 9.22.15

That leaves the stock trading at with just a 12x p/e multiple despite expectations for solid 9% in 2015. That’s a very reasonable valuation for a “best in breed” for its sector. This offers a good longer term entry point.

The Trade:

I’m going to keep this simple with the straightforward purchase of call options. I’m targeting the January $60 calls.. Specifically;

Buy January $60 for $3.75 a contract

These options expire January15, 2016 allowing plenty of time for the shares to regain their upward trend. My target is for the shares to make a new high above $66 by the end of the year which give the calls a minimum value go $6 for 60% gain.

— Steve Smith

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About the Author: Steve Smith