Forget Ford and GM, Buy These Stocks Instead

Just when it looked like the auto industry’s wounds from the recession were going to fully heal, disaster struck in Japan and cut off key auto parts supply lines for nearly every major manufacturer. It was out of the frying pan of weak demand, and into the fire of limited supply…

The car business isn’t a lost cause though, as some companies in the auto market are turning the industry’s lemons into lemonade.

#-ad_banner-#At the absolute worst time
The crimped flow of parts and components is expected to last for weeks, with its echoes lasting for months. It couldn’t have happened at a worse time, with car sales finally starting to get traction.

Take the nation’s large auto retailer chain AutoNation Inc. (NYSE: AN) for instance. The company posted a 26% improvement in first-quarter profits on strong sales of new vehicles (up 23% for the quarter), but in the very same statement dialed back its 2011 forecast for car sales in the United States. The new expectation of 12 million autos to be sold this year is 6.2% less than the prior outlook of 12.8 million. Why? Japan’s earthquake and tsunami have hindered auto production capacity, particularly for Japan-based Toyota (NYSE: TM), the world’s largest auto manufacturer.
Detroit’s iconic Ford (NYSE: F) and General Motors (NYSE: GM) have seen demand grow as well. As an example, Ford’s year-over-year income last quarter was up 22%, and the streak of higher year-over-year monthly unit sales is now approaching its second birthday. The company sold 1.93 million vehicles in 2010, up 19% from 2009’s total, confirming the industry’s rebound.

Unfortunately, Ford and GM will also be affected by the parts shortage. While each is expected to be able to meet its original production plans for 2011, neither is in a position to exceed its output plans this year.

A solution for consumers = opportunity for investors
All hope is not lost for investors, however. The situation just changes the approach.

Think about the car-related companies that can thrive in a high-demand/low-supply environment. There are two that come to mind: used car dealers and middlemen that facilitate the sale of used cars. The cream of those crops are CarMax Inc. (NYSE: KMX) and KAR Auction Services (NYSE: KAR).

CarMax operates used car lots in the United States. It’s not your typical used car lot, though. The dealer exclusively offers low mileage, late model vehicles, many of which still have some manufacturer’s warranty left. Technically, these autos aren’t “new,” but they’re very close to that in terms of quality, reliability and value.

The approach has been a surprisingly effective one. Though CarMax took lumps like most other business did in fiscal 2009 (which was mostly calendar 2008) with per-share earnings falling from $0.83 to $0.27 (a 67% decline), the company came roaring back in fiscal 2010 to earn a record $1.23 a share. Profits rose to another record of $1.66 per share in the past four quarters, and the current year is expected to be even better.

How has this company managed to do what so many other dealers and manufacturers can’t? Let’s face it — the deep-cutting recession has altered consumer priorities. Prior to 2007, a new car every few years may have been a way of life. Now it’s considered to be a needless luxury when a quality used car will suffice. Already in a sweet spot with car-shoppers, a lack of new cars to choose from is apt to drive even more would-be buyers to CarMax lots.

The other beneficiary of this unusual situation is KAR Auction Services. As the name implies, the company operates auto auctions, where drivers are also finding quality used cars as an alternative to expensive (and now unavailable) new vehicles. 

Though it wasn’t able to turn its 2007 and 2008 revenue into profits, the company continued to grow its top line since then and fought its way back into the black by 2009 with a per-share profit of $0.21. Last year’s $1.05 was another record, and 2011’s expected $1.25 would be yet another all-time high. 

Though perhaps a little frothy with a trailing price-to-earnings (P/E) ratio of 18.8, the forward-looking P/E of 15.7 is a little more palatable. Besides, KAR Auction Services has earned a bit of a premium with its reliable income and revenue growth.

Action to take –> Truth be told, it’s not like Japan’s hiatus from car parts production will be a permanent condition. It could linger for two to three quarters though, which is just enough time for the used car dealers to move from an “off the radar” status to a “must have” status and push these stocks higher as a result. Once the rest of the market is really turned on by the idea in late 2011 and early 2012, that’s the time to start heading for the door on this short-term (six month or so) strategic play.

If current trends persist, KAR Auction Services could advance as much as 30% before the hype starts to fade, while CarMax has a comparable upside for the same timeframe. That’s not gangbusters, but it’s not bad for half a year’s worth of work on a relatively low-risk holding. 

James Brumley owns shares of Ford. He did not own any other stock mentioned in the commentary at the time it was published.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…