Auto Retail Stocks: Too Far, Too Fast?

S&P says the group's recent strength appears unsustainable and its fundamentals are negative, though it does have buy ratings on two stocks in the subindustry

By Sam Stovall From Standard & Poor's Equity Research

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Except for shuttle launches from Cape Canaveral, I get a little too nervous when I see things go straight up—especially when it has to do with equity prices. The S&P 1500 Automobile Retail subindustry index has been among the best performers in the past 12 months. This absolute and relative outperformance may be due to investors' expectations that if consumers are hunkering down to protect their wallets during this recession by not purchasing a new car, they are most likely going to visit their local automotive parts retailer (rather than their costlier new dealer service departments) for service and or parts.

Year to date through Feb. 20, this group gained 5.1% vs. a 14.8% decline for the S&P Composite 1500 index, which consists of the S&P large cap 500, MidCap 400 and SmallCap 600 indexes. Yet its 12-month relative strength chart appears to be rising at an unsustainable rate.

Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's long-term mean relative strength.

Profits Won't Come from Car Sales

There are 10 large-, mid- and small-cap stocks in the S&P 1500 Automotive Retail subindustry index, two of which are not followed analytically by S&P equity analysts. Two of these index components have favorable investment recommendations: Advance Auto Parts (AAP), which carries a 5 STARS (strong buy) ranking, and O'Reilly Automotive (ORLY), ranked 4 STARS (buy). Auto Nation (AN), with a 2 STARS (sell) opinion, is the only member with an unfavorable investment ranking.

S&P equity analyst Efraim Levy, CFA, says S&P's fundamental outlook for the automotive retailers subindustry is negative, with a greater-than-normal amount of dealerships closing, including more than 900 in 2008. S&P expects hundreds more dealership to disappear in 2009. With the residential housing market tumbling, a more difficult credit environment, and lower consumer confidence, S&P expects reduced demand for big ticket items such as cars. However, bright spots include the sharp decline in gas prices to less than $2 per gallon, from a peak above $4, and the Federal Reserve including new-car dealer floor-plan loans in a $200 billion program, as this should help prevent some dealership failures.

Most auto retailers generate their sales and profits from four different operations: new vehicles, used vehicles, parts and services, and finance and insurance. New vehicle sales typically have the lowest operating margins, but drive business for more profitable finance and insurance sales and parts and services. With its forecast for lower new vehicle sales, S&P expects retailers to focus on generating more business from the remaining categories to offset lower new vehicle profits.

Squeezed by Credit and Competition

S&P now projects 2009 U.S. light vehicle sales volume will fall 14%, to about 11.3 million. Even the publicly traded dealerships' general overweighting towards import and luxury brands will not likely fully protect them in 2009, as S&P thinks dealers' sales and profits will also be penalized by lower overall new vehicle volume, a reduction in truck residual values, weaker used-vehicle demand, as well as possible reductions or slower growth in parts and services and finance and insurance operations.

Notwithstanding companies' claims of not being especially sensitive to economic cycles, results at publicly traded U.S.