By David Whiston
Many investors believe the automotive industry lacks competitive advantages, but we contend that each of the public auto dealership companies we cover has a narrow economic moat. The dealers may be off some investors' radar because of their relatively small market caps, but we think their moats are quite strong. Moreover, Group 1 Automotive (NYSE:GPI) and Sonic Automotive (NYSE:SAH) are both undervalued, in our opinion. We see the public dealers as long-term beneficiaries of continued consolidation among franchised dealers as smaller players continue to exit, enabling more market share gains, scale, and intangible advantages from the service business and optimal inventory allocation.
Parts and Service Create Pricing Power and Good ROIC
We think the dealer sector is the best business in the automotive supply chain from a competitive advantage perspective. We see all the franchise dealers we cover having two moat sources: cost advantage and intangible advantages. Lithia Motors (NYSE:LAD) has a third source of efficient scale thanks to its small-market focus. The public dealers centralize back-office operations and generate far more volume than a small dealer, which brings scale. Dealers have no burdensome retiree expenses, and the large public dealers do not depend on the health of one brand. The dealers enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margin on financing and insurance. Mergers and acquisitions also help a dealer's cost advantage and intangible advantage. The growing size of a dealer's store base enables more of the scale advantage above as well as more efficient allocation and pricing of inventory than a small dealer. For example, a dealer with many stores can take a used Toyota (NYSE:TM) Camry traded in at one of its Ford (NYSE:F) stores and send that Camry to a Toyota store in another part of town.
That said, we think the best source of competitive advantage is the parts and service operations, since the warranty gives the dealer an intangible advantage over an independent garage. Many customers bring their vehicle to the dealer for servicing because the vehicle is either under warranty or because the dealer is close to home and has the factory parts and expertise to service the vehicle. Once vehicle owners know a dealer, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle, and comparison-shopping for repair work is very time-consuming since the customer has to take the vehicle to each shop to get a quote.
These logistics create inelasticity of demand for service work, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. In fact, during a downturn in new-vehicle sales, dealers generally report higher gross margins due to a favorable mix shift, but then report lower operating margins due to selling, general, and administrative expense deleveraging. This trend occurs because parts and service is very profitable, with gross margins ranging from the mid-40s to more than 50%. Excluding large impairment and restructuring charges, dealers can still report positive EBIT even in a severe recession. The dealers we cover all have a weighted average cost of capital of 8.5%-9% and generate economic profit, defined as return on invested capital exceeding WACC. Penske Automotive Group's (NYSE:PAG) focus on luxury brands and leasing most of its real estate drags down its ROIC compared with peers. The firm gets about 70% of its revenue from premium/luxury brands. The wealthier client base means more customers pay cash or lease a vehicle; this is common in luxury and constitutes 55% of Penske's premium/luxury sales. This mix issue reduces Penske's opportunities to earn more finance and insurance business, which is a 100% gross margin segment for all dealers because of its commission nature. In 2013, F&I contributed 16.6% of total gross profit at Penske, compared with 23.6% at Asbury Automotive Group (NYSE:ABG).
Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth because they can be the most flexible in changing brand mix. In 2013, the largest 125 U.S. dealer groups increased new-vehicle unit sales by 14%, compared with 7.5% for the industry. We also think it is no coincidence that 6 of the 10 largest franchise dealers are public, including 4 of the top 5. This suggests that public dealers have the best capital market access to pursue mergers and acquisitions and fund store renovations. Since 1999, the 10 largest dealers have increased their share of U.S. new-vehicle retail sales. However, this change has occurred only in very small annual increments, showing the highly fragmented nature of the industry.
The dealers have a great business model, but we do not expect to award any of them wide moats in the near future. Dealers still have exposure to the vicious cyclicality of the auto industry, so we are not confident that they can always generate economic profit throughout a business cycle. Lost new-automotive volume results in SG&A deleveraging that cannot be wholly made up by parts and service. If a dealer has a highly leveraged balance sheet when a recession hits, it will be in trouble, as we saw in 2008-09 with Sonic Automotive. Moreover, there are some threats to the advantages enjoyed by the largest dealers.
High Fragmentation Means Moats Are Stable
We expect each dealer will continue to benefit from two industry trends. First, the number of new-car dealerships in the U.S. has fallen 30% since the end of 1987. The industry is consolidating, but much fragmentation still exists, as the 10 largest dealers were only 7.6% of 2013 new-vehicle unit sales compared with 7.7% in 2007 and 7.3% in 2002. This gives large dealers an opportunity to keep growing via tuck-in acquisitions; however, the relatively slow rate of these purchases prevents a positive moat trend. AutoNation (NYSE:AN) is the largest new-car dealer in the U.S., yet only had 1.9% of the new-vehicle market in 2013, up just 10 basis points from 2012. Partially offsetting this long growth runway from consolidation is the recent development of smaller dealers being more active in M&A than before the recession and partnering with outside investors who have far more funds to invest than the public dealers. Still, we think the public franchise groups will be able to comfortably grow via acquisitions and remain disciplined on pricing. The U.S. started 2013 with 17,635 dealerships, according to the National Automobile Dealers Association, and a recent study by Roland Berger Strategy Consultants estimates that 3,800 stores will close by 2020 as a result of collapsing margins if ownership is not consolidated into fewer and larger dealer groups. Such a decline would be about a 4% annual fall in the dealer count, far faster than the average 1.4% decrease since 1947.
Vehicles have become more technologically complex, and this favors larger dealers that can afford the equipment and training needed to provide service to today's vehicles. While dealers' competitive positioning is improving relative to independent garages, all franchise dealers enjoy this advantage and the industry is still very fragmented, preventing any one dealer group from gaining ground on another.
CFPB Threat Unlikely to Have a Major Impact on Public Dealers
The Consumer Financial Protection Bureau cannot directly regulate auto dealers because the National Automobile Dealers Association lobbied a carve-out to the Dodd-Frank Wall Street Reform and Consumer Protection Act. Direct dealer regulation comes from the Federal Trade Commission. In 2013, the CFPB launched a battle against the markup a dealer receives for arranging a loan by an outside lender to a customer. This markup is added to the consumer's interest rate and is called dealer reserve. The CFPB believes that minorities, women, and other protected classes are victims of discrimination by paying higher markups than similarly situated borrowers. Any variance is considered discrimination even if it is not intentional, under a term the CFPB calls "disparate impact."
NADA naturally, and in our opinion rightly, opposes the CFPB's viewpoint for several reasons. First, the average dealer reserve is less than 1%, according to NADA. Second, the CFPB refuses to disclose its basis for these allegations despite requests from NADA, the National Association of Minority Automobile Dealers, and members of both major parties in Congress, including members of the Congressional Black Caucus. There are many variables to determining an interest rate--such as FICO score, negative equity in a trade-in, and down payment--and we do not think the CFPB should ignore these before making an accusation. If the CFPB is considering these variables, then we do not understand why it would refuse to disclose this fact to stakeholders such as NADA.
The CFPB does not oppose dealers receiving compensation; instead, it wants dealers to receive a flat fee as compensation for arranging a loan. NADA opposes a mandated flat fee because it believes the consumer is already receiving a wholesale interest rate before the markup. A dealer's incentive to make a sale is aligned with the consumer who wants to buy a particular vehicle. If consumers had to go to several banks on their own it would waste time, and we are skeptical that a consumer with a poor FICO score would get a loan at all, or a loan at a lower rate than at a dealer. A flat rate could also give lenders less reason to make a loan. Under the current model, if a lender wants more business, it lowers its interest rate (what dealers call the buy rate), and dealers can also lower the markup if they want to make a sale. If a lender wants more business in a flat-fee world, then it has to raise the flat fee it is paying to attract more dealers, which it may be unwilling to do. Higher costs could also ultimately reduce credit available for consumers to buy a vehicle.
Our own conversations with dealers in our coverage support the claim of loans at wholesale rates, but also important is that the firms already cap the markup. The exact cap varies by lender but is generally between 2% and 2.5% on the high end. AutoNation, the largest dealer, has an average reserve of 125 basis points, and the majority of its reserve business is capped at 1%-2%, per our conversations with management. At NADA's annual convention in late January, the group recommended that dealers place a percentage cap on dealer reserve, never exceed it, and document reasons for any loans below the cap. This approach is very similar to a 2007 settlement some Philadelphia dealerships reached with the Department of Justice in response to discrimination allegations; however, the CFPB has not commented on NADA's proposal.
Despite the industry's objections to eliminating dealer reserve, it may still happen. The CFPB does not regulate dealers, but it does regulate the lenders that work with dealers, so the agency could change the rules to force lenders to compensate dealers via flat fees. Ally Financial recently settled CFPB allegations and paid a $98 million fine. Despite the penalty, CEO Michael Carpenter has publicly said Ally will not revert to paying flat fees. Another threat to dealer reserve comes from a California consumer group called Consumers for Auto Reliability and Safety. Several years ago, CARS succeeded in having California pass legislation that capped dealer reserve at 2% for loans up to 60 months and 2.5% for loans longer than that. In October, CARS filed a ballot initiative in California that seeks to eliminate dealer markups. California is the largest auto market in the country, and auto legislation there can be copied by other states. If other states ban markups, then lenders will be forced to give into the CFPB's proposal.
Why We Are Not Worried About the CFPB
Dealer reserve is classified in a segment called finance and insurance. F&I is a 100% gross margin business and typically constitutes nearly 25% of a dealer's total gross profit despite often constituting less than 5% of total revenue. This immense profitability may seem to be in jeopardy following a quick glance at a dealer's financial statements, but we do not see a reason to worry.
Dealers traditionally do not give much mix detail on their F&I operations but disclosed more information last year as the CFPB issue got more attention. Lithia's CFO said in July that the firm's preferred lenders, which constitute 75% of its financings, do not anticipate any changes to the process and that half of its loans already are on a flat-fee commission. Group 1 said in October that its lenders have not changed their practices because of the CFPB issue, and that only about 17% of its F&I revenue per retail unit sold comes from dealer reserve. Furthermore, nearly 70% of its F&I revenue per retail unit comes from product sales such as extended warranty, extended service plan, prepaid maintenance, and guaranteed asset protection, which have nothing to do with the CFPB issue. Our conversation with AutoNation revealed that about 40% of F&I profit is from financing while the rest is product sales. Management also has told us that a large portion of its deals are on a flat-fee basis already. Penske said in February that about 30% of its F&I income comes from dealer reserve in the United States.
AutoNation chairman and CEO Mike Jackson said in October that AutoNation has received several letters from lending partners regarding discrepancies of as low as $1 in monthly loan payments for six protected classes. The methodology used for selection remains secret, which Jackson thinks means that it is probably flawed and lacking statistical foundation. Despite this controversy, all but 0.001% of loans flagged for possible discrimination passed additional testing, while the remaining small sample need to be examined further. We doubt that the remaining loans are enough of an issue to lead to any major regulatory problems for AutoNation. Jackson also said that if a move to flat-fee compensation became a reality, it would be "manageable" for AutoNation since its commissions on dealer reserve are already in a "narrow bandwidth" and the company already receives a large amount of commissions on a flat fee. We agree with Jackson that any dealer that has been more aggressive in its markups may be in for a surprise. If the government eventually takes action to disrupt the dealer reserve model, we think the public dealers will not suffer. Instead, the change could present an M&A opportunity at the margin for the public companies if the change caused some dealers to exit the business.
Group 1 Automotive Is the Cheapest Dealer in Our Coverage
Group 1 is a 4-star stock with about 30% upside based on our $85 fair value estimate. The company has about 150 stores, mostly in the U.S. but also in the United Kingdom and Brazil. Among the public franchise auto dealerships, only Group 1 and Penske have operations outside the U.S. In 2013, Brazil contributed 11% of Group 1's new-vehicle unit sales while the U.K. contributed nearly 9%. The company's Houston base means Texas is its largest market at about one third of new unit volume. Texas, California, and Oklahoma are just over half of the company's new-vehicle unit sales, so Group 1 should benefit from GM's (NYSE:GM) recently released new-generation full-size truck and Ford's new-generation F-Series out at the end of this year. Ford is the company's second-largest automaker partner at about 12% of new-vehicle unit sales, while GM is about 5%. Group 1 is skewed to Toyota's three brands, which are nearly 27% of new-vehicle volume and its largest partner.
Our investment thesis is based on the moat argument presented earlier for all dealers and on conservative margin assumptions. We model roughly flat operating margins over our five-year forecast period relative to 2013 performance, despite possible upside this year due to cost savings from moving to one U.S. accounting center and reducing staff at a customer service center thanks to IT upgrades. Moderating these tailwinds is our expectation of slower growth in U.S. new light-vehicle sales this year to 15.9 million-16.2 million units from 15.6 million last year.
We see headline risk from Brazil as the largest threat to the stock this year. The company acquired Brazilian dealer group UAB in February 2013, and since then the Brazilian economy has seen an increase in macroeconomic uncertainty thanks to civil unrest and an election scheduled for the autumn of 2014. We are looking for just a slight increase in Brazilian passenger car demand, which could cause more bad news for Group 1 in Brazil this year. Group 1's Brazilian operations rely much more on new-car business than the U.S. and U.K., since buying used vehicles at a dealer and F&I are not as developed businesses for Brazilian dealerships. Therefore, a slowdown in Brazilian auto demand will probably delay any major benefits of Group 1 entering Brazil to beyond 2014. Management has seemed to acknowledge this risk by guiding Brazilian industry sales in 2014 to be flat at best and stressed that it is in Brazil for the long run because the middle class will grow by 10 million people over the next three to four years.
Sonic Automotive Is Cheap but Comes With Unique Risk
Investors who do not want headline risk in an emerging market could instead look at Sonic Automotive, which operates only in the U.S. Sonic is our other undervalued dealer at this time, with about 26% upside based on our $28 fair value estimate. Sonic has slightly more than 100 stores, with Houston, the Southeast, Los Angeles, and the Bay Area making up the largest markets and constituting nearly 80% of total revenue last year. About half of 2013 new-vehicle revenue came from luxury brands, with BMW the largest at 19.6%. For the overall brand mix, Honda is the next-largest brand at 15%, and Toyota is 10.1%. GM and Ford combined total 15%.
We think Sonic's more centralized procurement system implemented in 2011 and continued improvement in used-vehicle retail sales per store (sales of nearly 100 units a month, up from 50 in 2006), along with increases in industry new-car demand, will enable the company to modestly increase operating margins via SG&A leverage to midcycle levels of 2.7% in 2017 from about 2.5% in 2013. Rollout of the "One Sonic-One Experience" strategy starts in July with a pilot store in Charlotte, N.C. This initiative aims to make the car-buying process nearly paperless, place the customer with only one person for the entire transaction, and enable the customer to take delivery of a vehicle less than 45 minutes after deciding what to buy. We also like that the company is buying back its shares when undervalued. Buybacks in 2013 totaled $17.1 million, with $132.5 million still authorized for repurchasing stock.
The market does seem skeptical of Sonic, and we have some doubts ourselves, given the company's severe financial distress in late 2008 from debt, accounting issues delaying financial results, an ongoing material internal controls weakness surrounding the recording of new- and used-vehicle revenue and inventory valuation, and uncertainty around the company's plan to take CarMax head-on with Sonic's own stand-alone used-vehicle stores starting late this year. Still, we do not think our midcycle margin is aggressive, and from an operations point of view we think the company is a more efficient and healthy dealer than it was before the financial crisis. Also noteworthy is that various debt payoffs and refinancing have enabled Sonic to not have any major debt maturities until 2022.
Lithia Should Stay on Investors' Watchlists
Lithia's stock is trading near our fair value estimate, but it is one of our favorite dealers strategically speaking, so we think investors should keep it in mind when it is sufficiently undervalued. The company has the same moat sources we discussed earlier but also has a third one: efficient scale. Efficient scale is a competitive advantage garnered when a market is effectively served by a small number of players, creating a barrier to entry. In Lithia's case, about 80% of its 98 stores do not have a competitor for the same brand within 100 miles. The company is the eighth-largest dealer in the U.S. and primarily pursues a different geographic strategy from the other large dealers in that it focuses on small rural cities instead of large metro areas. Examples include Fairbanks, Alaska; Midland, Texas; and most recently Maui, where it owns the only Honda store on the Hawaiian island of 144,000 people. Shortly after this deal, the company acquired several other franchises for different brands in Honolulu. Texas, Oregon, and California were 57% of total revenue in 2013. Lithia is the one dealer we cover with major Chrysler exposure, at about 30% of new-vehicle unit sales. This exposure is to the best parts of Chrysler, however, with about two thirds of Chrysler unit sales coming from the profitable Ram pickup and Jeep. The growth runway looks excellent, with Lithia only in about 30 of 90 of its target markets west of the Mississippi and currently in zero of 180 possible Eastern markets. Lithia has no bank or bond debt other than floor-plan debt to acquire inventory, as well as no mortgage debt due until about $30 million in 2016. With its strong business model, we think Lithia is one of the best dealers in the sector and we maintain it is the Wal-Mart (NYSE:WMT) of auto dealers.