AutoNation, Inc. (AN) is the largest automotive retailer in the United States and we first became interested in the stock during the Great Recession. During that tumultuous experience and the subsequent bankruptcies of General Motors (GM) and Chrysler, the automotive retailer industry was in dire straits. We were buyers of the stock during that time and at one point AutoNation's stock traded below $4 for a short period. Ultimately we ended up selling way too early on the upswing, as AutoNation's extremely strong management team headed by CEO Mike Jackson came out of the crisis far stronger than before, while profits and the stock price have continued to increase. AutoNation's stock doesn't appear to offer an excellent value at current prices in excess of $40 per share, but understanding the business and management team could prove profitable during the next recession or economic crisis if shares once again become oversold due to external events.
As of September 30, 2012, AutoNation owned and operated 261 new vehicle franchises from 215 stores located primarily in the Sunbelt regions of the United States. The company is highly exposed to the regions that were hurt the hardest from the collapse in housing prices, as historically buyers would use resources such as home equity to fund large-ticket purchases such as automobiles. AutoNation is tremendously diversified in terms of automobiles brands with domestic, imports and premium luxury brands accounting for 34%, 37% and 28% of revenue in 2011, respectively. The company is far more focused on dominating local markets as opposed to emphasizing individual brands. By having several dealerships in the same area, AutoNation is able have extreme insight into buyer behavior and market conditions, allowing the company to leverage its improving IT infrastructure to efficiently control inventory management. While new and used vehicle sales account for the majority of AutoNation's revenues, it is the lucrative parts and services business that accounts for the highest percentage of overall profits.
Approximately 12.7 million, 11.5 million, and 10.4 million new vehicles were sold in the United States in 2011, 2010, and 2009, respectively. These anemic levels caused the average age of the light vehicle fleet to increase to 11 years. 2012 has been a much stronger year with sales growing by 13.5% to roughly 14.5 million. Barring some unforeseen development, 2013 bodes to be even stronger with sales between 15-16 million units. AutoNation has been using its size and efficiency to improve its market share versus its smaller competitors. I expect progress to continue and AutoNation's growing internet sales capability is likely to be a key competitive advantage moving forward. Buyers have the ability to negotiate their price, trade-in, and financing and insurance arrangements before they step into an actual store. Mike Jackson and AutoNation have consistently been ahead of the curve in terms of how cars have been sold, and the company's huge database of information from dealerships across the country allow it unparalleled access to add the most value to the internet purchaser.
New and used vehicle sales are only part of the equation for AutoNation. The company wants to provide its customers with a pleasurable and transparent sales process to ensure a lasting relationship. Because the company is often dominant in local markets, many times customers will come back to the same dealerships assuming they had a good experience the first time. In addition AutoNation makes extremely attractive profit margins on sales of financing, insurance and servicing plans. The parts and services business is also far less cyclical than sales of used and new vehicles, as was exemplified during the Great Recession when parts and services companies thrived while consumers held on to their vehicles for longer periods of time. Therefore the actual automobile sale is really the introductory transaction to enable the more profitable ancillary transactions. Importantly, the company doesn't take on substantial credit or insurance risks on cars sold, as AutoNation serves as a commissioned agent for third-parties that specialize in those areas.
Over the last decade AutoNation has invested an enormous amount of time and money to enhance its IT infrastructure. Through being both the largest automotive retailer and also having even more dominant market share in local regions, the company has unparalleled insight into consumer behavior. This is vital in so many ways including efficiently acquiring both used and new cars at attractive prices, while not becoming over-burdened with slow-selling models, which was a hallmark of the auto retail business not long ago. In 2012 the company completed the rollout of its Shared Service Center IT initiative to all of its dealerships. The Shared Service Center is responsible for end-to-end deal processing for all stores, therefore increasing automation and lowering costs from archaic practices such as all stores being responsible for their own individual accounting. Because the auto retail market has historically been highly fragmented, this type of huge and costly endeavor to homogenize best practices on a national scale have been very infrequent, and in fact aren't cost efficient for any company outside the largest national networks.
What has made AutoNation extremely unique is the company's stellar capital allocation. Edward Lampert has been the company's largest shareholder for many years, and the great investor's modus operandi of stock buybacks at discounts to intrinsic value seems to have been shared and executed with great acumen by management. Since 2002, the company has reduced the diluted share count from 322MM shares to 123MM, with an average purchase price below $17 per share. AutoNation's management has been able to skillfully return capital to shareholders' at attractive prices, while still enhancing the company's competitive advantages and growing market share. When dealerships have been available at attractive prices, management has been a willing buyer, but by refusing to grow for growth's sake shareholders, including Lampert and the second largest shareholder Bill Gates' Cascade Investments, have been richly rewarded. Since 2002, earnings per diluted share have grown from $1.19 to $2.33 over the last twelve months, despite net income actually shrinking from $382MM to $303MM over the same time period. I would look at the decrease in total net income as being more symptomatic of the economy as opposed to the business, and I believe that over the next several years AutoNation will post both record profits per share and net income.
Like most automotive dealers, AutoNation employs considerable leverage. Fortunately the company has been able to post returns on invested capital in excess of its actual cost of capital, which has created economic value for shareholders'. Operating margins have typically hovered around 4% and I do believe that as the company continues to reduce SG&A expenses as a percentage of total sales, margins have the potential to tick up slightly. As of September 30th, the company's leverage ratio was 2.74x, which is comfortably below the company's covenant limit of 3.75x. Long-term debt was approximately $1.892 billion versus shareholders' equity of $1.639 billion, but AutoNation generates significant free cash flow and can easily handle the interest payments.
Source 3rd quarter 10-Q
At $42.23 AutoNation has a market capitalization of roughly $5.2 billion. I believe that over the course of an economic cycle the company has the opportunity to produce normalized earnings of $300-$375MM. Peak earnings could be well in excess of $400MM, but as a fairly cyclical business I wouldn't be interested in paying more than 10-12 times normalized earnings for the stock. If management is able to buy back stock at discounts to intrinsic value, or selectively find opportune investments in other dealerships, intrinsic value could increase. I believe AutoNation is one of the best managed companies that I follow and I'm willing to pay a slight premium versus competitors based on the highly competent management team. I'd like to see a substantial sell-off to $20-$25 before I'd acquire the stock but this is surely a company worth following in hopes of finding that attractive long-term entry-point.