|Shares Out. (in M):||26||P/E||12.9x||10.1x|
|Market Cap (in $M):||1,919||P/FCF||12.5x||10.1x|
|Net Debt (in $M):||555||EBIT||273||328|
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Auto Dealers -- Sonic Automotive (SAH) used as example
Long – June 2013
See with charts at: https://docs.google.com/file/d/0B6RZm3GPDn8nTnNNY2FqNDQycEk/edit?usp=sharing
Note – this was a bunch of notes from March-May timeframe compiled in June. Stock prices aren’t all that different and looking at 100-200% type upside from here over 2yrs. The only thing to mention on this latest quarter is you are starting to see the P&S thesis below play out in the numbers (P&S SSS this last quarter accelerated for every dealer, this can be lumpy with warranty work but it’s been a multi-quarter trend of consistent acceleration). Also very importantly, AutoNation is starting to talk about this. They haven’t put real numbers around it yet and sell-side certainly isn’t modeling this upswing, but think AutoNation will start educating people which should be good for the multiples. You should certainly listen to AN’s call and you’ll notice the sell-side asking a lot of questions around this on all the other dealers’ calls for the first time.
I think the auto dealers are very attractive longs right now. There is enormous potential for profit growth on deceptively high quality businesses that are local monopolies with high ROIC, big barriers to entry and generate lots of free cash flow. There is modest upside on the front-end (car sales) part of the business with increased SAAR, but more importantly I think investors are overlooking a huge multi-year ramp up coming in the parts and services business which is the real profit engine of a dealership but not where investors/sell-side concentrate their analysis.
While P&S is only 12-15% of sales, it generates roughly half a dealer's gross profit. P&S is driven by the number of 0-5 year old cars on the road (so right now depressed levels ofSAARduring the downturn). Due to the lag on historical car sales, this fleet has been steadily declining straight into early ’12. Starting in late ’13/early ’14, this headwind will turn around and become a powerful source of growth as ’08, ’09 lowSAARyears cycle out. Ultimately the 0-5yr fleet normalizes 35% higher than it is today, a huge growth tailwind to P&S departments that should continue growing 3-5%/year in excess of the fleet. This dynamic hasn’t been seen since the mid-80s, long before the dealerships went public. In the 1980s the fleet of 5-yrSAARgrew 22% over the decade, industry-wide P&S grew at an 8.5% CAGR for the entire decade (with even higher same store sales due to net dealership closures).
With big growth in the dealers core P&S profit engine, incremental EBIT/GP around 50% (vs. 20-30% starting point), and redeployment of a ~10% FCF yield into accretive acquisitions and buybacks, earnings per share should grow 20-30% for the next few years and in the mid-teens for many years thereafter. There is great visibility to this growth given P&S’ lag toSAAR(i.e. analyzing history instead of the future), yet these stocks seem cheap at ~11-12x. I think SAH’s EPS can be 70% above consensus FY15 estimates and multiples should expand as investors start to pay attention to what is happening in parts and services and price in a growth trajectory that should last through the end of the decade well afterSAARstops growing.
I use SAH as an illustrative example whenever we’re talking specifics because it’s a very simple business. I think the best places to play are SAH, ABG and GPI, for reasons discussed below.
There is a lot I want to include here, but want to keep it manageable. So Section 1 is a three page summary of the opportunity. Since I have it already, I’m sharing a lot more detail in Appendices with charts/graphs that I think are useful. A lot of the charts and tables don’t paste in VIC, best way to see it is here: [https://docs.google.com/file/d/0B6RZm3GPDn8nTnNNY2FqNDQycEk/edit?usp=sharing]. It’s jamming thoughts collected over a few months together, so apologies if there is some repetition.
1) Section 1 – Summary
2) Appendix 1– Overview of the business
3) Appendix 2 – P&S and the 5yr fleet historically – the key thing to understand
4) Appendix 3 – What’s normalSAAR?
5) Appendix 4 – Comparison of the dealers
6) Appendix 5 – CFPB – the key risk
7) Appendix 6 – Cyclical upside in dealers vs. OEs?
Section 1 - SUMMARY
Easiest way to break down SAH is into 3 key levers – P&S growth, use of cash, multiples:
What upside does this sketch out?
I can’t share projections, so will just sketch out Sonic’s sensitivities to these drivers:
Why the opportunity exists:
Appendix 1: business overview
Auto Dealer attractiveness
Segment overview / Business Model (using SAH’s splits as guidepost, but generally similar across industry)
Note: while front-end is contributing ~50% of gross profit, it’s EBIT contribution is substantially lower as the majority of SG&A can be attributed to front-end sales (new & used sales commissions, advertising, floorplan interest etc).
New Car Sales - 53% of sales, 21.3% GP
Used Car Sales - 28% sales, 12.1% GP
Finance & Insurance (F&I) - 2.6% sales, 16.2% GP
Parts & Services (P&S) – 16.4% sales, 50.4% GP
What could be missing here? I’ve done a lot of work to try and tease out the counter-arguments, as this is the core of the thesis. I haven’t found anything too compelling. The best arguments this P&S growth are:
SG&A Cost Structure
People generally view gross profit as a revenue approximation here, as dealers think about things on a $margin per car basis rather than a percent basis (not that helpful to look at sales when you’re reselling $35k cars). The key line item below gross profit is SG&A, so I think of the SG&A to Gross Profit margin is similar to the way we’d think about an EBIT margin in a typical company.
Use of Cash
EPS to cash conversion is high in this industry most of these companies generate ~8-10% FCF yield as they trade ~10-12x earnings. There are a lot of high-return ways to utilize the cash
Valuation / How they trade
Appendix 2: P&S and the 5 year trailing fleet
Dealers make most of their money off of P&S, and this business has the highest incremental margins. This is directly tied to the population of relatively recent new car sales, which still come back to the dealer for service. P&S revenue potential on a car grows as it ages, but retention rates on those customers declines over time (retention rates highest and increasing most on luxury cars, lowest on low-end cars --- Dealer estimated for me a Hyundai might be 35% retention out of the gate vs. a BMW still has 60% retention year 5).
A couple of things to call out in the table above:
Additional factors that should help dealers retain a larger % of service stream:
That Chart above may not be readable it is so small, here it is in two pieces:
1980 - 1999
Yes we’ve seen it before, just before the professional lives of most of today’s investors / sell-siders
I’m always thrilled to hear the pushback that no, P&S only grows mid single digits, even during boomtimes in the 00’s. The auto cycle is its own cycle. Car sales peaked in ‘99/’00 and were roughly flat/down a bit through the rest of the 2000s. As such, P&S has a flat / negative tailwind for most of the 2000s, as seen in the red line below. Industry P&S bounced around flat and went negative in downturn. But going forward there is huge growth in the 0-5yr fleet coming – this is much bigger than the modest fleet growth in the ‘90s, and well beyond the growth in the ‘80s to (growth doesn’t look as sharp in projections b/c I layout a gradual SAAR recovery, but it extends longer – total growth in 0–5yr fleet is 33.5% from 2012-2020 vs. 22.5% in the 1980s).
What is very interesting here is you saw big, sustained growth in industry P&S revs in the 80s because that fleet was growing. P&S revs CAGR’s 8.5% growth for the entire decade, and stayed around 10% for most of the decade (this is not inflation-driven, inflation sub-3% from ’83 onwards).
0-5 yr fleet vs. dealer industry P&S rev (NADA data)
Same chart, but with 3-yr avg. industry P&S data to smooth out and see broader trend since the year to year has some volatility with recalls, weather etc.
Chart on left lays out growth in 0-5yr fleet over periods and corresponding growth in P&S. Note industry P&S grows well in excess of 0-3yr fleet, and an individual dealers’ P&S grows in excess of the industry as the industry continues net closing subscale mom & pop dealers and transferring market share to scale players including the public dealers.
Finally, I’m feeling better this dynamic will increasingly get broadcast by the dealers to investors. Auto Nation started showing a chart in February that shows some of this 0-5yr fleet. Think this should start getting talked about more as P&S trajectory really picks up, but dealers are afraid to get out in front of it, want to see the actual numbers coming through first.
Lithia this past Q also included a chart that shows their gross profit earned on a car over time, which should get people thinking about how dollars are driven as we roll throughSAARyears.
Appendix 3: What’s normalized SAAR?
This is included because I think it is really interesting and is incrementally bullish for the dealers long term. But the base case for the dealers doesn’t require SAAR upside, ifSAARstayed flat at today’s ~15.5m, think the stocks still can double.
People look at normalizedSAARa bunch of different ways – graph trends, replacement demand plus population growth. Consensus is for 16-17m typeSAARas a normalized level, back where it was for all of 2000s. There are some realSAARbulls out there pointing to higher numbers -- there has been population growth, the fleet is very old at this point and needs a refreshing etc. Employment of course helps. There is also a very convincing pent-up demand argument, the need to scrap and replace an unusually high number of cars, an argument I think makes sense but isn’t sustainable growth so I’m not going to put a multiple onSAARgetting pushed towards 20m if it will fall right back. For now I think its easy enough to justify 16-17m as the right normalized range, probably a little higher when employment (and miles driven) pick up, anything above that will just be a nice surprise.
Does “replacement SAAR” need to be 16.5-17m??
3 trillion miles driven / 250m cars in the fleet equates to 12k miles put on every car in the fleet ever year. If cars are retired on average with ~180k miles on the odometer and ~15 years old, then the US is chewing through 16.7m cars per year, just on replacement demand.
Does 16.5-17m make sense in historical terms?
16.5-17m of replacement demand seems to directionally make sense when you look at population vs. SAAR and miles driven vs.SAAR. Also, the recent flattening in miles driven has a lot to do with unemployment the slowdown in miles driven makes more sense on a per employee vs. per pop basis, unemployed people have nowhere to drive. So if employment picked back up it would seem miles driven should increase, perhaps to 3.3m on a recovered economy which would put replacementSAARat 18.3m units, before any pent up demand. Also interesting – I think most people are counting on construction to reduce unemployment. This is a particularly bullish forSAARas not only will re-employed workers buy personal cars, but the business itself is SAAR-intensive, requiring a lot of light trucks in particular.
Miles Driven per person
Miles driven per employed person
What could catch up demand be?
The fleet has aged a lot in the downturn. SAARdropped off in ’08, after which the average age of a car moved from 9.8 yrs to 10.8 yrs. When you start thinking hypothetically – if the average car should get scrapped after 180k miles (15 yrs), then maybe the average age of a car should be 7.5yrs. In fact it should be younger if the fleet is growing with time. However this yields ridiculous numbers like 50m+ units of pent up demand (per below).
Aging of US car fleet
Implied catch up SAAR?
If you thought about it a different way – How high wouldSAARneed to be just to keep average age flat? Well let’s assume that 250m carpark all ages one year. If we’re replacing 15yr old cars with new ones, we’d need to scrap that same 16.7m cars and replace them with 0 year old cars just to keep the average age of a car flat at these elevated levels. To reduce the average age by 6mo, we’d need to sell an extra 8.5m cars.
>>>Takeaway – looks to me like replacement demand might be 16.5-17m, over 18m if the economy recovers, in either case with medium term overshoots on pent up demand. But again, this is nice upside to have, since pent up demand would be unsustainable I’m not taking it into account in the models.
Other Charts that I thought were interesting to look at (mostly from BofA)
Appendix 4: Comparison of the dealer groups
There are some choices to be made. I think the most interesting ways to play this are SAH, GPI & ABG. They’ve got quality assets heavily weighted to luxury brands which are the most valuable and best secular growth. And they’ve got reasonable valuations. Each has their own wrinkle.
Before diving in, think its worth pointing that value in this industry is more driven by the assets (which brands & what locations), than the great mgmt teams, much moreso than your typical industry. Generally, I think good mgmt (AN, PAG, ABG) deserves a premium here, but it’s a relatively small premium. You can run a dealership better than the next guy, get better P&S retention, better margins, more efficient service, but you can only do so much better. These are franchises. They own the McDonalds location and can run it efficiently, but they can’t choose the menu, can’t choose the price, can’t run the main advertising campaigns. A dealer franchise with BMW inAtlantawill be heavily impacted by a) total demand for cars inAtlanta, b) BMW’s market share inAtlanta, and c) how many BMW’s are already on the road for the P&S department. These are all factors which will be driven more by macro and how good BMW is at designing and advertising desirable cars and gaining market share. No BMW dealer is going to be good at selling cars to people who aren’t in the market to buy a car, or people who want a Mercedes.
Capital allocation is important, efficient operation is important, and there is room for mgmt to drive better topline than competitors, its just more on the margin in this industry. So while I’m normally willing to pay a premium for great mgmt, in this case not willing to pay anywhere near the premium AN trades at, and really happy to own Sonic even though it’s a family business that has some operational issues and difficulty filing their financials on time (but they own a ton of great luxury locations benefitting from secular growth). The P&S trend we’re looking at will hit all these businesses no matter what, Sonic probably has the most to gain as incremental margins should be the same as everyone else, and with SAH at a lower margin starting point that will lead to more profit growth (and they could always get their act together and improve the business a lot).
At the back of this section there’s some good charts on the different businesses that can help you compare them from afar.
Talk about Brands / Geography
The following chart lays out brand exposure by dealer. On the right are two things I thought were interesting – first, where was FY12 sales relative to average ’04 / ’06 as a proxy for how far off the peak it is. Second, what was the growth pre-downturn as a proxy for secular trends. I focus on the secular. The cyclical column I think is a red-herring – of course D3 is down more b/c it always loses share and the markets were down. Luxury not as far off peak b/c it keeps gaining share and pushing further down into historically mid-range customers. I think all producers were at SAAR of 14.5m last year, market share has shifted so their sales are where they are, see no more upside for D3 cars than J3 cars from here even though the D3 brands are further from peak. Note: secular measures ’04-’07 units vs ’00-’03 units when 2% fewer cars were sold in total, so all “secular” trajectories have a ~2% understatement.
Below is a chart showing geographic exposure.
I think the best ways to play are:
Great assets – luxury focus and sunbelt exposure, attractive valuation. Biggest concern is SAH management– 2nd generation family business, by reputation is not as professionally managed as the rest. Recent late filing of 10-K (2nd time in 4 years) a good indication. But lower starting margins, lower starting F&I production, this all could be read as more potential. These guys will get all the same tailwind benefit coming and it should be a disproportionately large driver for them (same incremental margins on a lower starting margin base etc). They are spending a lot of capital on an “ipad” strategy right now, market is skeptical it will work, hard to tell for now, but at the very least its significant expense that can roll off if its not successful, and in the meantime, with franchise assets, I don’t think much irreversible damage can be done to the business beyond running expenses too high for a while. But the expense is already reflected in lower earnings, and SAH is getting a lower multiple on those earnings, so don’t see downside to the stock price from here on this strategy, just more upside potential. With high luxury brand concentration second only to PAG, the cheapest valuation and biggest upside potential, this is my favorite way to play this now that some of the others stocks have gone up.
Asbury (ABG) –
This is my favorite company, but it has run a bit more recently. Really impressive management team, they get ROIC, where to put money, how to drive service growth. CEO is former Autonation CFO and a very smart guy, whole team is impressive when you meet them.
Group One (GPI)
Good brand & geographic mix at a very reasonable price. Reputationally one of the better management teams, key concern is theBrazilacquisition, will GPI pour more money into investments that are a distraction to theUSthesis we want to own them for. High luxury and J3 exposure.
>>I usually just pass on this one, 35% of biz is inUKwhich dilutes the realUSthesis I’m focused on, stock gets a premium for playing with all these entrepreneurial new business options I’d prefer they not get involved with in the first place
Great management team – really like these guys, Roger Penske has a Steve Jobs reputation in the auto world. Stock gets a premium (known as the “Roger premium”). For my purposes, I would pay no premium for the entrepreneurial distractions -- I don’t want them wasting time and money testing out rental car franchises and building a distribution network for the SMART car that never arrived.
Biggest and the best. Eddie Lampert & Cascade have big positions. Great company, best thing about them is they just return all cash to shareholders (37% reduction in share count over 5 ys). Also more liquidity here. Problem is it consistently trades at a 4-5x premium to the rest, just no way to justify paying up for it since they’re all asset based business operating in the same country, facing the same SAAR etc. Fundamentally it’s worth the price – think AN will blow away expectations as this plays out, think it is cheap on the real earnings it will achieve. If this were the only option to play the space it’d still be a top position for me, but why pay 16x cash flow when there are so many ways to make the same bet at 11-12x cash flow.
These guys are mostly D3, in particular Chrysler. The lowest value dealerships out there (can buy Chrysler at 3x in private market while BMW costs 8x). Low quality customers, low quality cars, brand alignments hemorrhage market share, but like everyone else it will get to bounce off the bottom. In fact because it is such a low quality relationship with the customer and they don’t retain service on cars for long, the rolling impact of the 0-5yr fleet is really more like a 0-4yr fleet or 0-3yr fleet for Lithia. So it hits Lithia first, and it’s already showing up in their HSD P&S department numbers. Problem is that’s more than priced in b/c people like this as a “housing derivative” (high truck exposure, which rebounds with housing). So it’s now trading at a big premium instead of a big discount to the group.
Appendix 5: The CFPB risk
With certainty – this model will change.
How does it change?
So question is – is the change net negative, net positive, neutral for economics?
Secondary question– any backup defenses? (nice to haves, but I don’t think they will be needed)
>>>>>If others out there have done work on this I’d be very interested to hear what you’ve learned on this --- I’ve spent a lot of time speaking with people in the industry and this seems to be the consensus I hear amongst lenders & CFPB/industry watchers. Dealers seem confident they’re economics are safe (though you’ll see as you talk to dealers there is a wide variety of competency in this industry so that doesn’t always make me feel better). But I’m watching this like a hawk as it’s a big chunk of profit. Think this is more potential upside than downside, but will sleep better when the new system is set – hopefully very soon.
Appendix 6: Why does everyone tell me to forget about Dealers and Focus on OEMs/Tier1s?
I’ve found it interesting that over and over again people tell me dealers are the wrong way to play a recovery, better to focus on OEMs/Tier 1s. The argument is always that we’re in a SAAR recovery, dealers are defensive stocks, you only want to own them whenSAARis at peak. I think this is a reflexive reaction from guys who have been in the industry a long time that view the dealers as the low-beta players due to the stable P&S business. This was true for their entire public history when 0-5yr fleet was flat and P&S just grew slowly and steadily. It’s not the case today, but no one pays attention..
I view it differently. With OEMs/suppliers, you’re buying a SAAR recovery withSAARalready at 15.3m hoping it goes to 17m (plus whatever happens for better or worse in Europe & China). You get that same exposure with just as high incrementals on the front-end part of the dealers. But on the real profit driver, P&S, due to the SAAR lag, right now you’re buying that at the absolute SAAR trough (equiv to ~12m/year) going to 17mSAARwith the highest incremental margins relative to existing margins in the auto space. Seems like a better way to play this.
Anyway, given the unanimity of the advice I’ve gotten from sell-siders/buysiders I thought the charts below were interesting – lays out how FY13 EPS estimates have moved over time for OEMs, Tier 1s and Dealers as the SAAR recovery has taken hold over the last few years. OEMs/Tier 1s estimates have been falling, while Dealers are skyrocketing (showing which business model has better operational leverage – though to be fair OEMs/Tier1s also have non-US exposure). It also shows how the stock prices have moved.
OEMs/Tier1s stocks are up while EPS estimates are down, so even though we’re now much deeper inSAARrecovery than was expected, these stocks are getting richer multiples on more recovered earnings
Dealers on the other hand have seen FY13 estimates climb meaningfully, estimates up 20-50% in last 18mo, so their EPS seems to be significantly increasing with the SAAR recovery (due to high operating leverage on the front end business too, and P&S has still been a headwind this whole period just flipping to tailwind in ’13). Dealer stocks have risen, but not as fast, compressing multiples (e.g. today they get the same multiple on FY13 earnings as they got in ’10 when it was a 3yr forward multiple).
Note: these charts are 3 months dated now but I didn’t want to re-run them all, you get the idea, only looks starker with F/GM stocks running up further and earnings estimates not moving, whereas dealers stocks have increased less than earnings ests….
And with the OEMs you’re still buying largely fixed cost capacity utilization businesses where capacity is being added. Production is slightly more flexible than pre-bankruptcies, but still rigid, seems the biggest risk for OEMs is a price war if demand is softer than production schedules. Dealers don’t carry that risk and actually do very well in that scenario.
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