Selling cars in China is worse than making them

If you thought Chinese automakers were in trouble, try the companies that sell their cars. 

Investors have piled into auto dealerships' stocks, pushing some up as much as 90 percent over the last six months on hopes that one way or another, there will be demand. They're still up as much as 13 percent since the beginning of February, when the coronavirus crisis really took hold amid the usual slow buying period of the Lunar New Year. All that without a footfall in showrooms in a country that's gone into lockdown.

With the outbreak wreaking havoc across the auto supply chain, among others, there has been hope that Beijing will throw around stimulus to get China Inc. through another rough patch. A cratering car market could lead the government to support yet more purchasing incentives and other measures directed at consumers. Already, authorities in Foshan in Guangdong province are giving consumers a 2,000 yuan to 5,000 yuan ($286 to $715) subsidy per new car bought. Households could start talking about car ownership as a safer option to public transport or ride-sharing. After weeks of empty streets, signs that traffic is picking up in bigger cities has many believing sales could get a lift.

Speeding Up

Chinese auto dealerships' stocks have rallied in the absence of much good news.

Beijing can stuff cash into consumers' pockets but they can't drag them into showrooms. Potential buyers won't go into dealerships and wrap their hands around a leathery steering wheel and engage with fancy gadgets if they don't know who was touching them before. Yet as they sit at home, they're in theory a captive audience for sales pitches leading them to dealers' WeChat showrooms. One advertisement invites shoppers to check out cars in the online exhibition hall and "enjoy the new experience." Online sales could boost demand, the thinking goes.

Investors are perhaps reaching for cheery scenarios. Under the hood, the situation at dealerships is far worse. Earlier this month, their association pleaded with financial regulators to provide funding support due to "extreme liquidity pressure" as they expect sales to fall off a cliff. In a sign of desperation, one of the weaker but large dealerships for luxury brands like BMW AG and Jaguar Land Rover Automotive Plc tapped its existing bonds Tuesday for just $13 million at 12 percent for two years.

Dealers have good reason to be worried. Their businesses are inherently working-capital intensive. They're not turning inventory and sales fast enough to generate cash, and accounts receivable are stretched. Elevated inventories continue to tick up. Manufacturers can't pay dealers on time, and dealers haven't been able to meet sales targets that determine the rebates they get. Loan-backed sales could start to bite their auto finance arms as a weakening economy crimps consumer incomes.

Thinning Out

Dealers' margins are thin and at risk of shrinking further

As for stimulus measures and online showrooms buoying sales, hopes are thinning. Ultimately, buyers need to walk into a showroom and sign documents, whether or not they can pay some fees through WeChat or other platforms. Even the likes of Alibaba Group Holdings Ltd. have tried their luck at online car sales, and it hasn't resulted in much. As Jefferies Financial Group Inc. analysts put it, buying a car involves several interactions between buyers and other parties, including the dealer, and "the offline interaction requirements make online car sales almost impossible in the medium term."

Dealership earnings are primarily driven by new car sales. All else being equal, an increase of 50 basis points in new car sales margins boosts net profit by more than 10 percent, according to an analysis by HSBC Holdings Plc. Even if dealers manage to sell the heaps of cars they're sitting on, big discounts erode margins.

Other profit streams aren't looking so strong, either. Dealers have come to rely on various fees and after-sales servicing for a big portion of their earnings. More than 40 percent of profits, on average, come from fees they charge for things like financing, registration and pre-delivery inspection. With competition rising, those won't hold up. If sales are low, demand for servicing will also stagnate.

Caution, Mud on Road

Dealerships are trading above their long-term averages on a one-year forward price-to-earnings multiple basis.

Even with a helping hand from Beijing, the picture won't change anytime soon. More than three-quarters of dealerships will struggle to reopen after the coronavirus shutdown, the industry association said, because they're subject to cumbersome approval processes to get operations up and running again. A lack of employees because of travel restrictions and a shortage of face masks are also weighing on these companies, it said.

China's auto dealers are trading at an average 8.5 times their one-year forward earnings. For most of these companies, that's well above their long-term average of 7.1 times. All this is much better than carmakers themselves are faring. Investors can keep waiting for demand to pick up. But misplaced optimism can take this rally only so far.

Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.