4Q'06 Performance Suggests A More Amicable Industry Backdrop For Auto Retailers

I know, you have already received somewhere between 5 to 15 analyst notes about the December U.S. light vehicle sales. I used to try to race out a quick note giving you the data and a few thoughts, hoping if you got it from me first that you would read it. But when you start focusing on original thought, the timeliness becomes less important. Don’t get me wrong, if all you are looking for is regurgitated or summarized data, you were already served well by those earlier emails/notes, and this is not the email to be reading. But if you want to know what the December vehicle sales mean for the publicly traded auto retailers (earnings specifically), keep reading.

By now you have read that U.S. light vehicle sales in December were essentially flat. Actually, they were down a little less than 4% (from December of 2005), but a lot of the reports take the “daily selling rate,” a concept I am not a huge fan of.

Inventories. Inventories. Inventories.

But what really matters (in my opinion) are what the inventories are doing. Why is this such an important concept? For those loyal readers (going all the way back to my Wall Street days), I apologize for the repetition (you may want to skip ahead to the next section), but I think it is an important point to understand.

One of the biggest problem as an investment analyst is being able to figure out whether there is something that seems wrong (internally) at the company, or if the overall environment itself has become difficult. So what ends up happening is when a company has a really good quarter it always comes across on the conference calls that it was (internal) as management praises all of the initiatives they have put in place. On the other hand, when a company has a bad quarter, right away management teams start crying about how lousy the environment is and how high gas prices (for example) are hurting demand. I should point out there are also good and valid reasons for internal shortcomings (like making a strategic investment).

But my point is that we have little gauge (besides what management says on the conference calls) to know whether the performance (good or bad) was more related to what is going on in the overall industry (macro) environment or as a result of something happening internally (once again this could be good or bad).

And to make matters worse, the U.S. light vehicle sales trends have proven highly ineffective in assessing the industry environment. I’ve observed periods like the first quarter of 2002 where U.S. light vehicle sales fell (over 4%), but the peer group of publicly traded franchised dealers earnings and stock prices soared. Conversely, when you turn to the third quarter of 2002, when U.S. light vehicle sales were up nearly 9%, the peer group of publicly traded franchised auto retailers earnings and stock prices were getting hurt. It almost leaves an analyst left with relying on what management says about the environment.

So what is it about inventories that I think allows us to use it as a leading indicator of how the industry environment is really fairing for dealers? And it comes down to expectations at retail. At the dealership you have three types of expenses: 1) fixed (like the electric bill to keep your store lit), 2) variable (like the commission you pay to your sales person for selling the car), and 3) “controllable” meaning you tend to adjust it as demand trends change.

The three “controllable” expenses that I think cause the greatest variability in earnings (from one quarter to the next) at the dealership are: a) advertising expenses, b) inventory carrying costs, and c) sales personnel. Here again I’ve gone into these items in greater detail in other notes so these are very general examples. Also I plan to address the sales per sales person topic (with industry consultant commentary) tomorrow.

However, in an oversimplified manner, a lot of the advertising budgets are set 2-3 months (sometimes a bit longer, sometimes even over a shorter period of time). So if you are averaging 60 cars per month over a 3 month period (ignoring seasonality), and you are budgeting $200 in advertising expense per vehicle, and all of a sudden demand drops to 40 vehicles per month, you can see why for a quarter or two your budget could be “out of whack.” You spent $12,000 when you should have been budgeting $8,000 (well I think advertising should be more fixed, but that is a topic I have already addressed).

In the same manner, if you are paying ~$240 in floor plan interest expense per vehicle ($4 a day for 60 days), and all of a sudden you are holding the vehicle for 90 days (because sales came in weaker than you expected) now you are spending $360 per vehicle.

And finally, while sales people are primarily commission based, you have to understand that not every sales person sells 8 – 10 vehicles per month (once again I’m going to address this topic in greater detail tomorrow). Some sell 15+, while some of the “newbies” sell maybe (at best) a handful. It is during this training period when a modest investment is required on behalf of the dealer. So, using an example of a dealership selling 60 vehicles a month (imagining a market where there is no seasonality), if the dealer has determined that he/she wants to average 10 vehicle sales per sales person (per month) they will have 6 sales people on the showroom floor. But if demand drops to 40 vehicles a month, now all of a sudden you are averaging less than 7 per sales person.

The great thing about this business is that chances are, you don’t even need to lay people off. The seasoned veterans, that were selling 15+, now are averaging 10 or 11, and the “newbies” that were hoping to sell four or five, now maybe sold one or two (at best). While the new sales person may be getting a modest “draw” chances are they are going to conclude pretty quickly (over a couple few months) that this is not an attractive return (they are receiving) to put food on the table and they leave. And instead of hiring new people, the dealer just sticks with the 4 people that remain, bringing the average back to ~10 vehicle sales per person. If the demand goes back up to 60 people, now the 4 people are doing a lot better than the 10 vehicles per sales person average. Eventually the dealer will probably conclude that he/she needs to hire more sales people to keep up with the demand (customer service), but until he/she begins hiring “newbies,” the dealer is averaging 15 vehicle sales per sales person (i.e. not absorbing nearly as much training expense).

Starting to see why inventories tell us best what the industry environment really looks like? In the most basic sense, if inventories are declining, it suggests demand is coming in stronger than they budgeted, and these “controllable” expenses like advertising, sales per sales person (personnel), and floor plan inventory carrying costs are all lower than planned. Inversely, rising inventories tend to suggest that sales put more in their budget (for advertising, floor plan, and personnel) than the sales that materialized to support said expenditure.

Take the example of industry volumes and auto retailers earnings and stock price performance of 2002 (that I referenced above). In the first quarter of 2002, it was right after the 0% financing offers were completed by the automakers and dealers had benefited from record sales. So everyone expected demand to be down. And they did, down a little more than 4%. But the peer group of publicly traded franchised auto retailers saw (year-over-year) earnings growth of 35% as inventories fell 15% (year over year). Controllable expenses were clearly running lower than demand expectations.

But by the third quarter of 2002, dealers were becoming accustomed to higher demand trends, and so even though sales were up nearly 9% (year over year), the peer group’s earnings growth trends had slowed to 22%, as inventories were almost unchanged from the prior year levels. The stocks started to move down, recognizing the shifting tide (although most of us in the analyst community sat there baffled). Sadly it became clear by the end of the fourth quarter (of 2002), as inventories moved up 20% year-over-year (clearly dealers were expecting more than what demand was actually coming out to be). And the peer group of publicly traded franchised auto retailers earnings trends actually turned negative (to year over year declines) as four out of the six publicly traded players pre- announced lower than expected earnings. Those of us in the analyst community were now stuck with seemingly eroding earnings fundamentals, but much cheaper stock price valuations (like 7x – 8x after tax earnings).

We simply lacked a good understanding as to what was driving the ebbs and flows and could not make sense out of the industry data. Like I said, we could not make heads or tails out of the industry data, and were left at the mercy of the court (i.e. whatever management said on the conference). So my intent of explaining what really reflects the industry environment (inventories) is not to create a “trading” call. I’ve just seen too many funny things happen with investor psychology to navigate appropriately through it (because you have to take into account how much the stocks have moved up or down already in anticipation of the earnings announcements and also what the expectations might be going forward).

Instead, I really just want you to better understand what the industry backdrop is, so you don’t have to rely on management commentary about how good or bad the industry environment was (in order to explain their results).

Inventories and sales (as % of year) in 4Q06 suggest a more amicable industry backdrop for auto retailers

And from my vantage point, the fourth quarter industry data suggests a more favorable industry backdrop. U.S. light vehicle sales were up about 1% during the quarter (year over year), which as I have discussed itself tells us nothing. But based on the sales data, I estimate (and I caution this estimate is subject to change somewhat as the actual December inventory figures are reported), industry-wide dealer inventories were below 3.2 million units in December 2006, down more than 12% from the 3.6 million units of inventories the dealers ended December of 2005 with.

Importantly, if I take the unweighted average of dealer inventories for the fourth quarter of 2006 versus the fourth quarter of 2005, I estimate they are down ~5% (year over year). This is a dramatic reversal from the ~9% year-over-year increase dealers saw in their inventory levels in the third quarter of 2006 (versus 2005). I’m not saying the industry environment was a cakewalk, dealers still have to wrestle with higher interest rates. But, there was a noticeable improvement between the third quarter industry environment and the fourth quarter.

So if you look at the third quarter results reported out of the peer group of franchised auto retailers (granted it depends a lot what “extraordinary” items you include or exclude), earnings were up only 1% (versus the prior year period) with inventories up 9%. In the fourth quarter, if you take the consensus (as compiled by Zacks) of all 6 of the publicly traded auto retailers earnings, analysts expect about a 5% year-over-year increase in earnings per share. My estimates only call for (combined) earnings growth of ~1%, which means in hindsight I probably shot a little too far on the low side with my most recently published estimates.

In any case, the bottom line is that the industry environment, at least when you use inventories as a gauge, look to have improved. Will this surprise Wall Street? Perhaps. But the real point that I want you to take away is the environment is better, so be leery of any management team that claims things were tough in the fourth quarter.

Oh yeah, one other stat that I thought you might find of interest about the fourth quarter. Industry volumes for the quarter accounted for about 23.2% of full year sales, better than last year’s 22.3%, and five year mean average of 23.9%. Once again, suggesting that the fourth quarter of this year was better than the fourth quarter of last year, and as such, we should expect to see improved results.