Times are great for auto dealers. The seasonally adjusted annual sales rate for new vehicles topped 16 million in August, the first time it reached that mark since November 2007. But car sales are cyclical by nature, and it's not clear how long this upsurge will continue.
Anticipating an inflection point, or turn, in the sector would be very helpful for investors trying to judge a good time to exit a bullish position or set up a bearish one in the auto sector. One calculation -- the "auto dealer's days of sales in inventory" -- may help you identify such an opportunity.
What is the "days of sales" indicator and why is it useful?
This metric basically takes an auto dealer's dollar value of inventory at the end of a period, then divides it by the average vehicle sales reported per day in that period.
For instance, if dealer X has $100 million of inventory at the end of their third quarter, with average sales of $1.7 million per day for that period, they would have about 59 days of sales in inventory ($100mm divided by $1.7mm = 58.8).
Monitoring this number is helpful, because auto sales have been known to go through peaks and troughs. The industry has historically seen flush times when optimism reigns and beneficial economic conditions boost sales. But these good times have occasionally been followed by downturns, characterized by weak demand and vehicle oversupply. Excessively high auto dealer inventory levels, fueled by excessive optimism about future demand, often portend a coming sales drop. But if industry negativity pushes inventory figures below historic norms, a sales rebound could be in the offing.
Though it's not irrefutable evidence of an upcoming change in sales momentum, the days of sales in inventory calculation has been a useful tool in helping to forecast market conditions.
Data from four major auto dealers
In keeping an eye on the auto sector, I usually track inventory on four major auto dealers:
AutoNation (NYSE:AN) owns and operates 267 new vehicle franchises, which sell 33 new vehicle brands across 15 states. It is America's largest automotive retailer and a component of the S&P 500 Index. AutoNation had 2012 sales of around $16 billion.
Penske Automotive Group (NYSE:PAG) operates 323 retail automotive franchises, representing 39 different brands, and 30 collision repair centers. It has 171 franchises in the U.S. and 152 franchises located overseas, primarily in the United Kingdom. Penske is a member of the Fortune 500 and Russell 2000 with over $13 billion in sales last year.
Sonic Automotive (NYSE:SAH) operates 111 dealerships in 14 states, representing 25 different brands of cars and light trucks. It also runs 20 collision repair centers and had revenues that topped $8 billion in 2012.
Group 1 Automotive (NYSE:GPI) owns and operates 139 automotive dealerships, 178 franchises, and 35 collision centers in the United States, the United Kingdom and Brazil. It offers 33 brands of automobiles and had more than $7 billion of sales in 2012.
Since vehicle sales are seasonal, it's important to look at comparable quarter over quarter relationships. The most recent second quarter data shows:
What does the information suggest?
The figures seem to propose that dealers generally prefer to hold around 58 days to 60 days of sales in inventory at the end of their 2nd quarter.
The rise toward mid-60s days of sales in dealer stock in 2008 might have hinted toward the weakening of demand that would lie ahead. Conversely, the meaningful drop toward, and even below, preferred lower-end inventory levels in 2010 and 2011 could have suggested the industry was overly pessimistic, and a rebound might be forthcoming.
Since the recent recession stymied many new car buyers and created significant pent up demand, car sales may continue to improve for some time. But with second-quarter inventories again approaching the mid-60s days of sales figure, investors might want to tread carefully. At a minimum, since the entire auto food chain, from dealers, to car makers like Ford and General Motors, to parts manufacturers like BorgWarner and Dana Holdings, are all near 52-week highs, you might want to make sure you're fully comfortable that optimism in the industry isn't excessive before you take a long position.
The auto industry often gets overly enthused during good times, and overly pessimistic during bad. New vehicle sales peaked at a 17 million annual rate in 2005, then dropped to around 10 million in 2009. Now, with the figure topping 16 million, it's possible that the easy gains have already been made. Plus, with auto dealers' days of sales in inventory near uncomfortably high levels, you might want to proceed with caution if you're considering investments in this sector.
Bob Chandler has a short position in Ford and BorgWarner. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.