Summary

At Cash Flow Compounders, we seek high return on equity, high growth companies, with fortress balance sheets. When these names trade at discounted valuations, we recommend purchase. Our latest find is Asbury Automotive Group (ABG).

Big picture, car dealerships are great businesses. Low capital intensity, high variable cost structures, and less cyclical than most people realize. At Asbury, earnings per share surprisingly hit a record in Q2 (up 6% yoy), despite US new car sales falling 34%. Cost cutting, used car sales and improved margins all contributed. ABG’s cost structure is impressively 70-80% variable. They can flex costs to match demand quite quickly.

The number of registered cars on the road, a better driver of earnings for auto dealers, continues to grow. From 2016 until 2019, cars on the road grew by 1.7% per year. Considering that the US population has grown at 0.7% per year, car ownership continues to expand.

Below is a chart of cars on the road in the US dating back to 1990:

The pandemic has created a few interesting near to intermediate term shifts.

One, not only is mass transit now frequently unavailable, but with Covid-19, commuters today are less inclined to get on a subway or bus. Used car prices have recently hit an all-time high according to Manheim data.

Two, auto OEMs entirely shut down capacity for almost two months this year, leading to a shortage in new cars available for sale. This impacted Q2 revenue, but not profits so much. Gross margins per car jumped across both used and new car fleets.

Three, in the intermediate term, the secular shift in population to the suburbs is real, and will likely mean increased car buying / ownership. How long this migration lasts is hard to gauge, but if reports that ~20% of workers will permanently work at home are true, then the shift could last 1 to 3 years.

And finally, lower interest rates simply make cars more affordable. Demand right now is solid, with Lithia, Group One and Penske all reporting earnings results double what they were a year ago (in the September quarters). ABG pre-announced EPS in the $4.00 to $4.04 range, up 70% year over year. Quantitative Easing and low rates will mean plenty of available capital through 2023 assuming Powell is true to his word.

On the negative side, auto dealers are viewed as being disrupted by online car buying. We would point out that physical dealers have lost zero OEM market share to online dealers, who only sell used cars (Carvana or Vroom or Acceleride, which is owned by Group One). They also offer no servicing at all.

That means there is no digital disruptor on 70% of their business profits (assuming half of F&I is related to new cars).

While there is profit in used vehicles, car sales only generate 4-6% gross margins on average at Asbury. In per car terms, a used car on average sells for $21,000 today, generating $1,500 in gross margin. There are no barriers to entry in the used car space, but the profitable dealers make money via trade ins. That means a steady inventory of advantaged-cost product to sell.

The biggest component of value for an auto dealer like Asbury is in the Parts & Service business, which generates 60% gross margins, as well as in financing and insurance (F&I). Extended warranties and selling loans generate fees and have only administrative, overhead costs, and small reserves (meaning outsized ROE’s).

This is borderline a razor and razor blade business model. Online players can only sell the low margin razors, the used cars, and are completely missing the parts and service side, where the real money is made.

Finally, ABG closed in August on the purchase of 13 franchise dealerships from Park Place Group in Texas. This is a nice acquisition of a high-end luxury (i.e. high margin) group of dealerships in one of the fastest growing markets in the US. At 9x 2021 EBITDA, and 8x 2022, it is attractively priced, and looks to be 20% accretive to 2021 ABG earnings per share.

In sum, we estimate EPS can hit $13 next year, maybe $14 per share. At its typical 11-12x earnings multiple, we target a range of $143 to $170, upside of 25% to 50% in the next one to three years.

The downside is perhaps $100. We posted our buy recommendation when ABG traded at $95 last month for subscribers.

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Chart of Stock Price vs P/E (in green, left scale)

ABG has admittedly run up significantly since we first discussed it way back at $78 (Recovery Stocks Worth Considering) . While the stock has run, a disciplined strategy of buying some today, and down to perhaps $100 makes sense.

Looking at the graph above, ABG has de-rated from almost 20x TTM earnings in 2015 (in green), to a TTM P/E of 15x. Of course, forward estimates including the Park Place deal put the 2021 earnings multiple at a very cheap 9x.

The 10- and 20-year average P/E multiples both are 11.3x, so we are a bit above long term averages on a trailing twelve month basis, but well below that proforma for the Park Place deal.

The range of P/E multiples has been between 8 and 14x since 2011.

On $13.05 in 2021 earnings, that suggests a potential a wide range of values from $104 to $183 per share.

Capitalization

While leverage is a bit elevated today, at 3.58x on a debt/EBITDA basis post the Park Place acquisition, it is lower than most of their peers. The company is high yield (BB) rated, but with their 2028 bonds yielding 4.1%, it is safe to say that the market views the company as de facto investment grade. Also, like HCA, our one other Compounder with a high yield rating, Asbury owns the property on 69 of their 88 dealerships (as of the end of 2019). This property is easily financeable (perhaps REIT-able), should the company ever need capital, and worth well more than book value.

Liquidity-wise, the company has $730mm of cash and revolver capacity, and should generate roughly $200mm of free cash flow over the next 12 months. Management aims to repay debt with free cash near term. On their recent conference call ABG said that they expect to be below 3.0x debt to EBITDA within 18 months.

There is $66mm left on their share repurchase plan today, but is not likely to be utilized near term.

Business

Asbury Automotive was founded in Atlanta in 1995, and IPO’d in 2002 at $16.50 per share. At the time the company owned 91 dealerships, and generally had a goal to own “the best dealers in the best markets with the best brands.”

The stock has returned 11% per year to investors since then, vs the S&P up 8% per year.

With the Park Place deal closing in August, ABG now owns 99 dealerships with 118 franchises. Proforma, 49% of their revenue is derived from luxury brands like Mercedes, BMW and Land Rover. These tend to be higher margin, and more stable brands as luxury buyers tend to be less impacted by economic cycles. Parts and services margins are also exceptionally high for European luxury imports.

While online competition is a risk to some extent on the used car side, Asbury already generates 20% of sales of their cars fully online today (perhaps those sales should get a Carvana multiple at 5x revenue). The company launched their “Omni-channel” marketing focus four years ago, which basically entails the company listing and selling cars online, offering online and app means of booking servicing appointments as well as digitizing documentation.

While this is a “retail” business, it is impossible to disintermediate new OEM car sales (per franchise agreements, they are not going to go digital anytime soon). Plus, cars require maintenance and repair, plus financing. The dealership model simply works.

Management at Group One (GPI) suggested that Tesla’s direct distribution model coupled with mass car sales will create enormous servicing problems in the coming years. As an example, there is only one service location for Tesla’s in the greater Houston area, population 7mm people. These owners apparently are calling other dealers in hopes of getting service.

This is a listing of Asbury’s brands pre-Park Place. Geographically speaking, Asbury is in favorable, growth regions, particularly Texas and Florida.

Segments

The company breaks down their business into four segments.

New Vehicles

OEM’s and auto dealers enter into franchise agreements. While there are national standards in place, for example no dealer can own more than 4% of the US market, there are no restrictions at the local level. That means owning two Mercedes dealerships in a certain area (like Hendricks Mercedes in Charlotte), often affords them a near monopoly in a market.

A broad generalization is that an imported car earns 2% margins, a US car 4% margins, and a luxury import 6% margins. Import margins are slim, but this includes names like Toyota and Honda, so volumes bigger. At Asbury, the company earned $700 per import car sale, $1700 on a US OEM sale, and $3500 on a luxury import sale last quarter. These amounts/percentages move around depending on mix.

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Used Vehicles Retail / Wholesale

Dealers make better gross margins on used cars when sold as a trade-in. Buying a used car at auction and flipping it is tougher. A used car is slightly higher margin than a new car, but the average price is lower (at $21,000 last year in revenue, and earning $1500 per car sold).

Parts and Service

Servicing vehicles is 41% of ABG’s gross margin. Particularly with imports, but increasingly with all cars, mom & pop repair centers are less equipped to fix and properly maintain a car. Parts on most luxury imports are monopolies too. Mercedes and BMW are known to build highly complex engines, which in many cases can only be repaired by a certified dealer.

The shift to pure electric vehicles is an interesting conversation. EV cars have far fewer parts and require far less maintenance. However, according to GPI, repairs to an EV, while less frequent, tend to be far more costly. The five year cost of maintenance (excluding gas), is roughly the same for a Toyota Corolla as it is for an electric Nissan Leaf.

Mom and pops are even less equipped to repair the electronics in an electric vehicle (or in any car built today with so much technology).

Finance and Insurance

Dealers usually don’t offer loans directly. They can instantly get quotes on a potential buyer at the point of sale (or online). They do collect a fee on the loan origination however. Dealers also like to tack on extended warranties. Again, these fees are high margin, and for ABG, make up about 28% of their total gross profit.

This is a better chart:

Long term, parts and service has performed quite well:

Park Place Acquisition

Asbury struck a deal to buy Park Place Dealerships LLC for $1BB back in December 2019. On March 24th, the company paid a $10mm breakup fee to walk away from the transaction. On July 6th, terms were amended to a deal whereby ABG would purchase 13 franchise dealerships instead of 19, at a reduced price of $735mm.

The company stated that it is paying 7.8x post synergies EBITDA.

Here is our math assuming a three-year even cadence synergy picture.

At the bottom is our earnings accretion analysis. A cash deal, done at super low rates (financed with a couple bonds at 4.5% and 4.75% maturing in 2028 and 2030), looks to add $1.85 to EPS in 2021. This might be conservative, as JPM modeled $54mm in incremental net income, or $2.82 in accretion in 2021.

With Street estimates at $10.37 for 2020, we get at least $12.22 in consolidated EPS in 2021. Adding in a bounce off of a low SAAR’s year, and ABG should be able to get to $13-14 in EPS next year. Synergies are expected to total $20mm. The good news is that Park Place and ABG’s dealers run on all of the same IT and administrative platforms. Integration should be easy.

Total US car sales in 2019 totaled 17.0mm (down slightly from 17.3mm in 2018), and plummeted to about 8mm in March, but have already recovered to 16.4mm as of September. Management at one of ABG’s peers suggested that car sales probably remain flat until we have a vaccine, but that appears likely in late Q4 and ramping up in Q1 and Q2 2021.

Given the roughly $2.00 pop in 2021 earnings, this transaction arguably adds $20-25 in value to ABG shareholders.

Growth Trends

Overall revenue growth at Asbury has been 3.5% since 2015 (through 2019), but grew rapidly from 2010 through 2014 (10.4% per year). Parts and Services has grown steadily at about 5.2% per year in gross profit.

The Great Recession wasn’t a disaster for Asbury, despite the fact that financing markets seized up for a time. 2007 EPS clocked in at $1.38, 2008 at $1.47 (excluding an impairment charge), and finally bottomed at $0.74 in 2009. Parts and services revenue remained flat in 2009 as compared to 2007 (at $622mm).

In all, there is a cyclical element no doubt, but here is a long-term chart of EPS since 2007.

Asbury has generated an impressive 12.4% CAGR in earnings per share. Since 2014, the company has invested $524mm in growth capex, and expanded EBITDA by $100mm. ABG management deserves credit for those kinds of ROIC.

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Compare this to SAARs data (seasonally adjusted annual sales), which hasn’t really done much in 20 years.

Light Weight Vehicle Sales: Autos and Light Trucks

Here is ABG revenue going back to its IPO.

2021 includes approximately $1.7BB in revenue from the Park Place deal.

Model and Forecast

Our detailed model is below:

ABG income statementThe summary version, our FCF model is here:

Valuation

Our diligence suggests that the best quality names in the auto dealer space are Lithia (LAD), Penske (PAG), and Asbury (ABG). Ones with heavier overhead, and deemed not to be as well run include Autonation (AN), Group One (GPI), and Sonic (SAH).

ABG comps

You can see in this comp sheet that the highest margin players are PAG, LAD and ABG. Leverage appears elevated at PAG and GPI. While GPI looks cheap on a P/E basis, it is actually at a normal valuation on an EV/EBITDA basis.

Asbury appears to be high quality margin-wise, with its 30% ROE’s well above its peers, and growth-wise is the second highest behind LAD, but not trailing by much at 17% vs 18%. You get this at a below average multiple on 2021 estimates.

While the group trades at 9.4x current year EBITDA, and ABG at 10x, this fails to account for the cash flow from Park Place (but includes the debt). So, on 2021, ABG at 7.7x is a large discount to peers today.

We find the entire group generally attractive. The one negative is that EBITDA margins are not particularly high. But as pointed out above, dealers borderline give away cars to get the parts & services business. They also get the high margin fees associated with the F&I business. Lots of customers remain very loyal to a dealership over time too.

We did not include Carvana (CVNA) or CarMax (KMX), as purveyors of used cars is a different ballgame. CarMax is a pretty well run however, capturing 6.5% EBITDA margins, but it hasn’t grown as quickly as ABG (but 15% in the past five years though is pretty good, just 2% lower than ABG). Despite similar growth, it garners a 16x multiple on 2021 earnings, almost 2x ABG’s valuation.

We think overall that ABG is almost as high quality as LAD, which trades for 14x forward earnings. ABG should trade pretty close to LAD.

Here is our valuation matrix.

We have been told that private transactions today are occurring at higher valuations than where public names trade today. One dealer said he wouldn’t consider selling his dealership under 10x EBITDA. Out of 20 deals I looked at between GPI and ABG since 2012, only Park Place and one Nissan deal disclosed terms publicly. Almost every transaction has been a purchase of 1-5 dealerships, so tend to be small.

Conclusion

Asbury checks all the boxes for a great business. High ROE’s, barriers to entry, low capital intensity, and we think solid management given their track record and the Park Place deal economics. The CEO, David Hult, joined ABG in 2014 as COO, and was elevated to CEO in January 2018. One hedge fund group Abrams Capital owns 11% of the shares, with a 5% stake taken in Q3 2017, and another 5% in Q3 and Q4 2018 (am guessing a $60 average cost basis, or around 8-9x current year earnings).

Asbury stock has had a nice run, and may take a breather. But we recommend adding shares on any pullback. As a Compounder, this one likely has years of growth ahead of it.

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Disclosure: I am/we are long ABG, LAD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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