Description

So consumer, retail and automotive exposure may not quite be what most people are looking to add to their current portfolio but Asbury Automotive (ABG) is a terrific value investment.  ABG which owns auto dealers, has the potential to more than double and pays a 6.4% yield while you wait.  It has a market capitalization of approximately $450m (32 million shares x $14), long-term debt of $475m and cash of roughly $50m for a TEV of $875m.  The stock currently trades at just 7.5x consensus earnings estimates.  It arguably trades at well below 6x EPS in a normalized environment.  They key to the value of ABG is the resiliency of its business model.  Even in a recession, and I assume we are in one, ABG will generate decent earnings, pay its dividend and increase its long-term earnings potential through attractive acquisitions.   

Business Model    

Years ago the Company made a strategic decision to focus on foreign and luxury brands.  This was a brilliant move that explains a great deal of why ABG’s earnings can hold up even in a weak market.  Over 80% of ABG’s new car sales are luxury or mid-line imports.  Investors in this space closely track SAAR (Seasonally Adjusted Automotive Retail sales) and freak out when they decline.  But SAAR is a very high level number and does not say anything about market share.  The domestic manufacturers have driven a great deal of this decline.  During the first quarter, for example, Chrysler sales declined 15.9% while Honda (ABG’s largest new car brand at approximately 30% of sales) declined only .4%.  The Company also has a balanced business model that sells both new and used cars and provides service and financing.

The Company’s strong parts & service and finance operations make it more resistant to economic downturns.  While 85% revenues are generated by car sales, parts and services and financing generate almost 60% of gross margin.  In 2007, the revenue and gross margin contribution were:

Parts & services are not cyclical like car sales.  If you need your car fixed, you get it fixed.  If anything, consumers will rely more on servicing to defer having to buy another car during tough times.  The Company anticipated growing this area of the business during 2008.  While financing volume is dependent on car sales, it is a very lucrative business for ABG with no risk.  ABG simply collects a fee from third party providers- the Company has absolutely no balance sheet risk associated with its financing revenue.  By selling both new and used cars, the Company also makes itself less volatile during tough times.  Used car sales have typically shown less cyclicality than new cars during economic stress.  But if manufacturers become aggressive with incentives in response to the downturn (making new cars relatively more attractive than used cars), the benefit to new car sales will help offset the loss in used car sales.

While SAAR will no doubt decline this year (though the brands which ABG owns will fare relatively better), ABG should earn $1.40-$1.50 even in a 14m SAAR, which is a deep recession.  How low could SAAR go?  During the consumer recession in 1990 SAAR fell to 11.3m.   Since that time the US population has increased from approximately 250m to 300m (or 20%).  So growing recession SAAR by population gets a trough value of 13.6m.  But the average car ownership per capital has also increased- families in the US simply own mores vehicles.  If you take this into account, a SAAR of 14m seems appropriate number for a deep consumer recession scenario.  To be clear, SAAR is not currently at this level and manufactures are projecting total production of a little over 15m (approximately the level in the first quarter this year).   Last year SAAR was 16.3m.  The table below shows historical SAAR for prospective:

In our model, we assume continued market share gains for luxury and foreign (it is hard to imagine this not being the case) but sales declining steeply in every area (this could be conservative if domestic sales really implode).  We assume sales compensation is variable (commission determines much of these numbers) and that the Company will cut certain S, G & A areas such as advertising and outside services with a slight decrease in personal, with other segments growing with inflation (rent, utilities, etc.).  Financing revenues decline with fewer cars sold while parts & services remain steady.  Based on these assumptions, we get $1.47 in EPS at a 14m SAAR and $1.82 at a 15m SAAR.  These numbers seem consistent with conversations we have had with the Company as well as other analysts.  It should be noted that the Company will save money on its floor plan debt this year (this is the debt provided by the manufacturers to finance inventory, it is generally not included in long-term debt but the interest cost is taken out of EBITDA) as much of it is floating rate.  So the interest rate decline has helped ABG and if continued economic weakness necessitates the fed keeping rates low, ABG will benefit.

So on trough earnings, the Company trades at less than 10x EPS.  The stock is cheap in an almost worst case scenario.  Even taking a recession as given, the Company may still earn more than $1.50 .  Management is currently guiding to $1.80 to $2.00.  While we think the low end maybe more likely based on current trends, that is still a very nice earnings number.     

Dividends

The Company’s dividend is safe even in a deep recession that lasts through 2009.  ABG currently pays a $.90 dividend for a yield of approximately 6.4%.  Under its bond indentures, the Company can pay approximately 50% its earnings in dividends.  However, it also has a $20m carve out for dividends and share repurchases, which increases what it can pay out in dividends.  The Company has approximately 32m shares outstanding.  So if even if earns $1.50 for 2 years, the basket will enable it make up the difference and keep its dividend.  That’s a nice yield while you wait for the story to play out.

Catalysts

The stock is priced for a recession.  So the bar is set very low.  It is hard to see much downside from here (perhaps back to its 52 week low of just under $12) and the upside is considerable.  The stock traded at $30 in April 2007.  Even then it was not expensive.   As investors look for stocks that anticipate an economic recovery, ABG should bounce as long as its earnings are not disastrous.  While its not a specific event catalyst, I don’t think it will take much to get ABG moving. 

Risks

The most obvious risk is a macro economic melt down on a scale beyond what I have used in my model as a recession.  While possible, I think it is unlikely.  Other risks include:

§         Automotive finance scarce.  ABG did have weaker earnings in the second half of 2007 as finance for subprime buyers for its used cars became less available.  While this is an issue it primarily impacts used car sales and only a minority of its buyers are sub prime.  Our due diligence indicates that financing for cars remains reasonably stable as the loans are considered safer than most (they are collateralized, the collateral is easily sold and most people are very reluctant to default on a car loan as they often need their car to get to work).  

§         Florida exposure.  ABG does have considerable exposure to the Florida market and this area of the country is more economically challenged (though ABG’s exposure is mostly in the northern part of the state, which is doing relatively better than the southern area).  This is a known risk and the Company has baked it into its guidance but clearly the economic conditions could always be worse than predicted.  On the positive side of Florida, the state is growing significantly in population and the number of luxury and foreign dealers is basically fixed.  

§         1Q earnings could disappoint.  It is a cyclically weak quarter and indications are the macro environment remains rough.  So maybe able to enter a lower prices in the not too distant future. 

Conclusion

In normalized conditions, ABG can earn over $2 per share (it earned $2.09 in 2007).  Over time, its earnings potential has grown both through organic growth and accretive acquisitions.  Management of ABG is very strong and they are extremely well regarded within the industry.  Its dealerships are very valuable.  They are great brands (Honda, Toyota, BMW).  Each dealership is a local monopoly- by legal agreement, another competitor will not emerge.  

What is the stock worth in the long-run?  Penske Automotive (PAG) has indicated in meeting that it looked at buying ABG for north of $20 (so 40% or more upside from the current price).  People I have spoken with in the industry believe the break-up value (simply selling off all its dealerships) of the Company, even in this distressed environment, is also north of $20.   I think ABG is worth closer to $40 in the long-term.  The Company’s real earnings power is in the $2.50 and higher range.  At a 15x multiple you get a stock price of $37.50.  That is great return even if it takes 2-3 years and along the way you are getting a great dividend stream.      

Catalyst