Lithia Motors Inc.: Investment Thesis
Financial projections for Lithia Motors Inc. (LAD), incorporating analysts’ EPS estimates, indicate an investment in shares of the company at the current price of $299.84 could provide a wide range of possible returns, from negative (9.6)% to positive 14.8%. Uncertainty equates to risk, and such a wide range of possibilities indicates a high degree of risk. My own view is the results in 2020 are an aberration and it would be very unwise to think these results will be repeated in subsequent years. On that basis, the shares are very much over priced at present. The share price has more than doubled since the end of 2019, so there’s a long way to fall. Before I proceed with my standard in-depth review for share mispricing, I would like to share some additional thoughts on Lithia Motors EPS growth prospects past, present and future. Table A below compares results for the nine months ended September 30, 2017, 2018, 2019 and 2020.
Net income in Table A agrees to the company’s reported results, but I have moved things around a little to better highlight issues. For example, I have included Floor plan interest expense as an operating expense, so my operating income will be different from that reported. I also included lines for EBIT and EBT. Comments on the contents of the Table A follow (all comments are for the respective nine-month periods).
- Total revenues for 2020 were down by $221 million (2.4%) on 2019, primarily due New vehicle down $369 million and Fleet & Other down $89 million, offset in part by Used vehicle retail up $$257 million.
- Total gross profit margin was fairly similar for 2017 to 2019 at 15.1% to 15.5%. For 2020 total gross profit margins have increased to 17.2% with all business segments contributing. However in absolute terms, vehicles provided $91 million of the $122 million increase in gross profit for 2020 over 2019. Vehicle margins were apparently driven in turn by a shortage of supply increasing margin per vehicle. From discussion in the Q3-2020 earnings call this supply imbalance may persist into Q1-2021.
- Total operating expenses for 2020 versus 2019 would have been up by $32 million but for a $27 million reduction in Floor plan interest expense. The reduction in Floor plan interest expense is assumed to be due to reduced stock of new cars, and may not repeat in future periods.
- Operating income increased by 10.0% and 8.5% respectively in 2018 and 2019 and by 36.9% in 2020. This 36.9% increase almost certainly will not be repeated in 2021, as it includes items like a temporary increase in vehicle margins due to supply imbalances and the reduction in Floor plan interest. These are expected to reverse in 2021, rather than being a source of further increases in gross profit.
- Results for EBIT and EBT growth in 2018 and 2019 were fairly modest, EBIT 7.4% and 8.5% respectively, and EBT 1.5% and 8.2%, respectively. However net income growth for 2018 was 32.1% and for 2019 negative (1.1)%. The reason is the effective tax rate which was 39.1% for 2017, 20.7% for 2018, and 27.5% for 2019. Results for 2020 for EBIT, EBT and net income are all elevated due to the higher operating income.
- Diluted EPS growth was 34.2% for 2018, 5% for 2019, and 39.6% for 2020. The higher EPS growth for 2019 compared to 2018 is due effect of share repurchases.
In summary, do not expect the conditions that increased margins in 2020 to persist in subsequent years. Also, with the higher share price, share repurchases become less economic. And do not expect share price growth to benefit in the future from the level of multiple expansion that has occurred in 2020. Rather, expect multiple contractions back to closer to historical levels to cause significant falls in share price. Please read on for details of how these factors will affect likely returns.
Looking for share market mispricing of stocks
What I’m primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the “E” in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.
Table 1 – Detailed Financial History And Projections
Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2022 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note estimates are shown for analysts’ EPS estimates out to 2024 where available, but these are considered not as reliable). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7% per year through the end of 2022 (see line 12), based on buying at the Dec. 1 closing share price level. The table shows to achieve the 7% return, the required average yearly share price growth rate from Dec. 1, 2020, through Dec. 31, 2022, is 6.30% (line 41). This growth rate is lower than the target 7% return due to estimated dividends receivable. Lithia Motors has a current dividend yield of 0.41% (line 37). Table 2 below summarizes relevant data flowing from the assumption of a target 7% total return.
Targeting a 7% Return
Table 2 – Targeting a 7% return
Table 2 provides comparative data for Lithia Motors, assuming share price grows at rates sufficient to provide total rate of return of 7%, from buying at closing share price on Dec. 1, 2020, and holding through end of 2022. All EPS estimates are based on analysts’ consensus estimates per SA Premium.
Comments on Table 2 are as follows:
Part 1 – Consensus EPS (Case 1.1) (lines 1 to 12)
Part 1 shows the amounts the share price would need to increase to achieve a 7% rate of return through end of 2022. From Part 1, it can be seen that adding projected EPS growth rate to a dividend yield can give an approximation of potential total return, subject to changes in P/E ratio and growth in the dividend yield on cost.
Part 2 – Required change in P/E ratio to achieve Target 7% return (lines 21 to 23)
Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to end of 2022, to achieve the share price level at the end of 2022 necessary to achieve the targeted 7% return. For Lithia Motors, the P/E ratio at buy date can decrease by 32.1% through end of 2022 and the 7% return will still be achieved. Being able to achieve a targeted return despite a reduction in the P/E ratio would normally be regarded as a positive. However, due to the distortions of earnings and sentiment owing to the COVID-19 pandemic, it’s difficult to judge whether the change in P/E ratio is a positive or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre COVID-19 starting point.
Part 3 – Projected change in P/E ratios from 2019 to 2022 (lines 31 to 46)
In Part 3, I start with the share price at Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The end point is projected share price at end of 2022, when it’s assumed the market and earnings are no longer materially impacted by the pandemic. For Lithia Motors, the share price needs to increase by $193.53 from $147.00 at Dec. 31, 2019, to $340.53 at end of 2022, and as detailed in Part 1, at $340.53, the targeted 7% rate of return would be achieved. For Lithia Motors, there are a number of givens in our assumptions. Using these givens, the change in the share price from Dec. 31, 2019, to end of 2022, can be expressed as mathematical formulae as follows:
(A) Change in share price, due to effect of EPS growth rate, equals share price at beginning multiplied by (1 plus average yearly EPS growth rate) to the power of number of years invested.
= $147.00*(1+30.5%)^3 = $326.58
(B) Change in share price due to change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio).
= $326.58*(1+4.7%) = $340.53
The increase of $179.58 ($326.58 minus $147.00) due to the average yearly EPS growth rate is cumulative, and share price will continue to increase – the longer the shares are held and the growth rate continues. The increase of $13.95 due to a change in the P/E ratio ($340.53 minus $326.58) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.
Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.
Understanding The Dividend Growth Income+ Club Approach
Total Return, Dividends, Share Price
The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.
Changes in Share Price
Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock specific.
Earnings are tipped into the “Equity Bucket” for the benefit of shareholders. It’s prudent to check whether distributions out of and other reductions in the “Equity Bucket” balance are benefiting shareholders.
Lithia Motors’ Projected Returns Based On Select Historical P/E Ratios Through End Of 2022
Table 3 below provides additional scenarios projecting potential returns based on select historical P/E ratios and analysts’ consensus, low and high EPS estimates per Seeking Alpha Premium through end of 2022.
Table 3 – Summary of relevant projections Lithia Motors
Table 3 provides comparative data for buying at closing share price on Dec. 1, 2020, and holding through the end of 2022. There’s a total of nine valuation scenarios, comprised of three EPS estimates (consensus, low and high) across three different P/E ratio estimates. Comments on contents of Table 3 follow.
Consensus, low and high EPS estimates
All EPS estimates are based on analysts’ consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely, to high based on analysts’ assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as Lithia Motors. I believe the “low” estimates should be considered important. It’s prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.
Alternative P/E ratios utilized in scenarios
- The actual P/E ratios at share buy date based on actual non-GAAP EPS for September 30, 2020, TTM.
- A modified average P/E ratio based on 16 quarter-end P/E ratios from Q4 2016 to Q3 2020 plus current P/E ratio in Q4 2020. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
- A median P/E ratio calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded.
- The actual P/E ratio at February 21, 2020, share price, based on FY 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent, and after FY 2019 results had been released. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic.
Reliability of EPS estimates (line 17)
Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are three analysts covering Lithia Motors through end of 2022. In my experience, a range of 18.3 percentage points difference in EPS growth estimates among analysts is a very large difference, suggesting the estimates should be treated with caution.
Projected Returns (lines 18 to 39)
Lines 25, 32 and 39 show, at a range of historical P/E ratio levels, Lithia Motors is conservatively indicated to return between negative (9.6)% and positive 11.1% average per year through the end of 2022. The negative (9.6)% return is based on analysts’ low EPS estimates and the positive 11.1% on their high EPS estimates, with a negative (1.7)% return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios. At the high end of the projected returns for Lithia Motors, the indicative returns range from negative (6.6)% to 14.8%, with consensus 1.6%. The difference between best and worst cases is an indication of a high degree of uncertainty in analysts’ estimates.
Review Of Historical Performance For Lithia Motors
Lithia Motors: Historical Shareholder Returns
In Table 4 below, I provide details of actual rates of return for Lithia Motors shareholders investing in the company over the last six years.
Table 4 shows returns have been excellent for investors buying shares in Lithia Motors over the last six years. For all eight of the cases above, returns have been in the double digits, ranging from 20.1% to 105.1%. Based on those results, investors might well ask, what’s there not to like about Lithia Motors? I believe this is a case where investors should heed that warning, “past performance is not a reliable indicator of future performance.” Table 1 (lines 22 and 23) shows share price grew at similar rate to EPS growth for the three years 2019 to 2022. Since the end of 2019, Table 1 (line 37) shows the share price has slightly more than doubled in the eleven months through Dec. 1, 2020. Lithia Motors has performed far better than expected through the COVID-19 pandemic, but only over-exuberance can explain a doubling in the share price. The rates of return in Table 4 are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to fourth quarter 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares, and the duration the shares are held.
Checking Lithia Motors’ “Equity Bucket”
Table 5.1 Lithia Motors Balance Sheet – Summary Format
Table 5.1 shows Lithia Motors has increased net assets used in operations by $1,740 million over the last 3.75 years. The increase was funded by $784 million in equity and $956 million in net debt. The $784 million increase in shareholders’ equity over the last 3.75 years is analyzed in Table 5.2 below.
Table 5.2 Lithia Motors Balance Sheet – Equity Section
I often find companies report earnings that should flow into and increase shareholders’ equity. But often the increase in shareholders’ equity does not materialize. Also, there can be distributions out of equity that do not benefit shareholders. Hence, the term “leaky equity bucket.” This is not happening with Lithia Motors as explained below.
Explanatory comments on Table 5.2 for the period Jan. 1, 2017, to September 30, 2020:
- Reported net income (non-GAAP) over the 3.75-year period totals to $1,024 million, equivalent to diluted net income per share of $42.73.
- The company shows solid net income growth over the period ranging from 11% to 16% per year. This is largely due to the above mentioned acquisition in the middle of the period, which is still being bedded down.
- The non-GAAP net income excludes $41 million of items regarded as unusual or of a non-recurring nature in order to better show the underlying profitability of Lithia Motors. These adjustments decrease reported non-GAAP EPS compared to GAAP over the 3.75-year period by $1.62 per share.
- Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund – these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders’ equity at any point in time. For Lithia Motors, these items were $9 million negative and decreased equity per share by $0.40 over the 3.75-year period.
- There were share issues to employees, and these were a significant expense item. The amounts recorded in the income statement and in shareholders’ equity, for equity awards to staff, totaled $65 million ($2.77 EPS effect) over the 3.75-year period. However, the market value of these shares is estimated to be higher by $5 million ($2.92 EPS effect) than the amount recorded for stock compensation expense purposes over the 3.75-year period. In accounting terms, it’s not a material understatement of the real cost of stock compensation.
- By the time we take the above mentioned items into account, we find, over the 3.75 year period, the reported non-GAAP EPS of $42.73 ($1,024 million) has increased to $43.81 ($1,051 million), added to funds available for distribution to shareholders.
- Issues of staff shares, assessed at estimated market value, increased equity by an estimated $70 million over the 3.5 year period and there was a further issue of shares raising $2 million. These increased funds available for distribution to $1,123 million. Of this $1,123 million, $236 million was expended on share repurchases and $103 million was paid in dividends to shareholders, leaving a balance increase in shareholders’ funds of $784 million.
Lithia Motors: Summary and Conclusions
Based on analysts’ estimates of future earnings, and a P/E multiple far above historical levels, the stock appears very much overpriced at present.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.