Auto Profits Shift to High Gear

 | Sep 07, 2013 | 6:00 PM EDT
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I was bullish May 9 on the shares of Tesla (TSLA). With the stock up 140% since then, it turns out I was right. It's clear sales at Tesla are electric. But what about the other parts of the car business, like the dealers and the other automakers?

On Sept. 4, U.S. auto dealers said sales for August had their best month in six years. Automakers sold 1.7 million vehicles, up 17% over last year. At the current rate, the industry is on track to sell more than 16.09 million cars and trucks this year.

Sales rose 14.7% at General Motors (GM) in August, making for that company's strongest month since September 2008. Cadillac sales rose 38%, the division's best monthly number since 1989. Buick sales increased 37%, the strongest monthly result in at least a decade.

Ford (F), for its part, posted its best August since 2006. Ford sales increased 12% and Chrysler sold 11.5% more cars and trucks. Toyota (TM), Honda (HMC) and BMW saw increases of 22.8%, 26.7% and 45%, respectively.

Leasing and low interest rates got buyers into a new car. According to, leasing accounted for about 26% of new vehicle sales in 2013.

The recovery in the U.S. auto market has been remarkable. In 2005, the industry sold 17 million cars and trucks. Of those, 77.6% went to higher-margin retail buyers, while the remainder were sold as fleet vehicles to rental companies and other volume buyers. The industry bottomed out at 10.4 million units during the dark days of 2009, when it looked like General Motors wouldn't survive. Since then it's been up, up and away. Right now, the industry is on pace to exceed 16 million units, which almost gets us back to the 16.1 million units sold in 2007.

More important, the industry has reduced its dependency on fleet sales. Analysts estimate that 82% of new vehicle sales will be sold to retail buyers this year.

Investors have noticed. General Motors' stock, for example, is up 23%, and Ford is up 28% year-to-date.

Despite the strong stock performance, I think the automakers can go higher. This year, sales at General Motors grew just 2.56%. Sales are expected to increase 5.84% to $165.3 billion next year.

Two things are driving auto sales. First, millions of vehicles are coming off lease over the next two years. Most buyers head back to the dealership and drive away with a newer model of the same brand. Leasing has turned consumers into loyal buyers. Second, there is pent-up demand. We had five years (2008 to 2012) of below 16 million units. Because of the recession, millions of buyers put off buying a new vehicle. Those buyers have to come into the market over the next two years in order to upgrade their junkers.

Because of the higher sales volumes and lower dependency on fleet sales, gross margins should increase from an estimated 14.15% in fiscal 2013 to 15.45% in 2014. That 130-basis-point jump in gross margin will drop right to the bottom line. General Motors is expected to produce earnings per share of $3.40 in 2013 and $4.55 in 2014.

If GM can keep posting sales increases of 4% to 5% until 2015, gross margin will tack on another 100 basis points simply due to higher to higher manufacturing volumes and lower costs. Earnings could easily hit $5.35 per share. That would mean 16% compounded annualized earnings growth -- not too shabby for a company all but written off as dead a few years ago.

The same dynamic is happening at Ford. The only difference is that this company is less dependent on leasing. Only 15% of buyers lease vehicles from Ford. Higher unit volumes are driving better gross margins, and earnings are moving much higher.

If you are looking for a different angle, I suggest you look at the retailers, like CarMax (KMX). CarMax is the largest retailer of used cars in the U.S. Last year, the company sold almost 450,000 used cars.

In the first quarter, CarMax reported earnings per share of $0.64, $0.06 better than expected. Revenue rose 19.3% year over year to $3.31 billion. Total used unit sales rose 22%. Same-store sales increased 17%. As long as interest rates stay low and financing is easy to come by, pent-up demand should continue to drive strong sales at CarMax.

Analyst estimates look low to me. For example, the Street is expecting earnings per share of $2.18 and $2.39 for fiscal years 2014 and 2015, respectively. But those estimates assume just 12.2% revenue growth for 2015. With strong vehicle demand, I think CarMax will be able to get 14% or even 15% revenue growth. Heck, same-store sales in the first quarter were 17% and should carry into quarter two. If I'm right, the stock should trade closer to the mid-$50s over the next six months.

CarMax could also see accelerated used-car sales as automakers jack up prices in the face of an improving market.

Year-to-date, the shares of automakers and used-car dealers have been strong. The stocks are backed by solid fundamentals. Pent-up demand, easy financing, low interest rates, lease expirations and improving gross margins all point to higher share prices. I think investors in the auto sector can drive away with higher profits.

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I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
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