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Sonic Automotive Inc (SAH), Penske Automotive Group, Inc. (PAG): Mismatch Between Valuation and Profitability Makes This Stock a Buy

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Mean reversion is a powerful force that no one should ignore. The average length of ownership of new vehicles has jumped from 8.4 years in 1995 to 10.8 years in 2012. Add cheap financing to the equation and the outlook for U.S. auto sales looks bright.

Sonic Automotive Inc (NYSE:SAH)

Sonic Automotive Inc (NYSE:SAH), one of the largest domestic auto-dealership groups, is a proxy for that growth. In addition, its stable maintenance and repair business will help to cushion any potential disappointment in auto sales. Moreover, its strategy of owning  dealership properties gives it additional control and flexibility. Sonic Automotive Inc (NYSE:SAH) has the lowest forward P/E and highest ROA among its peers; this mismatch between valuation and profitability makes the stock a buy in my books.

Why the U.S. auto market is on the uptrend

Firstly, there is serious pent-up demand from consumers. One key indicator is the average ownership period of a car. According to the results of a 2012 study by Experian Automotive, Americans are staying with their existing cars for an average of 10.8 years in 2012. This not only represents a 9% increase in average vehicle age from 9.8 years in 2008, but also a quantum leap from 8.4 years, the average age of cars on the road in 1995.

Secondly, for big-ticket items like cars and homes, consumer confidence alone is insufficient to drive demand without cheap financing. According to Equifax Inc. (NYSE:EFX)’s National Consumer Credit Trends Report, new credit for auto loans amounting to $69.6 billion was originated in the first two months of this year, representing a 73% increase over the new auto credit of $40.2 billion for the same time period in 2009. This is an indication of both the availability of cheap credit and rising approval rates for auto customers.

Repair and maintenance to the rescue, if things do not work out

If the rosy picture for the U.S. auto market does not materialize, Sonic Automotive Inc (NYSE:SAH) still has its dependable repair and maintenance (or fixed operations) business to fall back on. When your car malfunctions, you can hold back maintenance for a while, but not indefinitely. The non-cyclicality of the repair and maintenance business explains why Sonic Automotive Inc (NYSE:SAH) has achieved profitability in nine out of the last 10 years in the past decade. It derives about 14% and 46% of its revenue and gross profit, respectively, from this business segment.

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