AutoNation Still Far Too Expensive

| About: AutoNation Inc (AN)

Summary

AutoNation shares have fallen off of their highs after reporting earnings and July sales.

Still-rapid sales growth has not been enough to satisfy investors as expectations are far too high.

AN is a sell on valuation and risk to the business.

After nearly being left for dead during the financial crisis, shares of AutoNation (NYSE:AN) have soared, cresting $60 under two months ago on an unbelievable recovery in the new car market in the US. The car dealer has seen strong earnings underpin this rapid growth in the share price as terrific macro fundamentals along with strong operating performance have helped lift shares. After missing earnings in July, shares tumbled to the $54 level where they trade now. Is this a buying opportunity or the end of the rally? In this article, we'll take a look at AN to see if it is worth adding to your portfolio.

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To do this, I'll use a DCF model that you can read more about here. It uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at zero for the foreseeable future, and a discount rate, which I've set at the 10 Year Treasury rate plus a risk premium of 7.5%, reflecting the cyclicality of auto sales and the fact that the long bull run in car sales could be running out of steam.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.98

$3.34

$3.74

$4.34

$5.03

$5.84

x(1+Forecasted earnings growth)

12.10%

12.00%

15.97%

15.97%

15.97%

15.97%

=Forecasted earnings per share

$3.34

$3.74

$4.34

$5.03

$5.84

$6.77

Equity Book Value Forecasts

Equity book value at beginning of year

$17.93

$21.27

$25.01

$29.35

$34.38

$40.22

Earnings per share

$3.34

$3.74

$4.34

$5.03

$5.84

$6.77

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$17.93

$21.27

$25.01

$29.35

$34.38

$40.22

$46.99

Abnormal earnings

Equity book value at begin of year

$17.93

$21.27

$25.01

$29.35

$34.38

$40.22

x Equity cost of capital

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

=Normal earnings

$1.78

$2.11

$2.48

$2.91

$3.40

$3.98

Forecasted EPS

$3.34

$3.74

$4.34

$5.03

$5.84

$6.77

-Normal earnings

$1.78

$2.11

$2.48

$2.91

$3.40

$3.98

=Abnormal earnings

$1.57

$1.64

$1.86

$2.13

$2.43

$2.79

Valuation

Future abnormal earnings

$1.57

$1.64

$1.86

$2.13

$2.43

$2.79

x discount factor(0.099)

0.910

0.828

0.753

0.686

0.624

0.568

=Abnormal earnings disc to present

$1.42

$1.35

$1.40

$1.46

$1.52

$1.58

Abnormal earnings in year +6

$2.79

Assumed long-term growth rate

3.00%

Value of terminal year

$40.37

Estimated share price

Sum of discounted AE over horizon

$7.16

+PV of terminal year AE

$22.91

=PV of all AE

$30.07

+Current equity book value

$17.93

=Estimated current share price

$48.00

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As we can see the model produced a fair value of $48, or roughly $6 less than shares trade for as I write this. That is a decent sized discrepancy, so does that mean AN shares are overvalued, even after tumbling from their highs?

Before we tackle that question we need to know what we're looking at. The model produces a fair value and not a price target. A price target is a multiple of estimated EPS at some point in the future where a price is projected out. A fair value is the value of shares right now based upon certain assumptions. Basically, the model says the current intrinsic value of AN, given the inputs I described above, is $48 based upon the discounted present value of the company's expected earnings stream.

Now that we have that out of the way, what does it mean? The model is certainly implying shares are overvalued and in this case, I agree. To begin, just have a look at the earnings estimates analysts have on this stock right now; AN is currently expected to post 12% to 16% earnings growth each year for the foreseeable future. After having grown rapidly in the past five years on terrific execution of strategy but also, to a large extent, due to a strong resurgence in consumers' willingness to buy new cars, what is left to fuel that kind of growth?

Indeed, we may have seen the first crack in the armor with the earnings miss earlier this summer that sent shares plummeting off of their highs. In the report the company announced that same store sales for the quarter were up 6%. That is a terrific number and yet, wasn't good enough to satisfy investor appetites.

Subsequently, the company reported July sales, showing same store sales increasing 7% and total vehicle sales up 8% and once again, shares were punished. These are strong numbers but, as investors so brutally pointed out, they weren't good enough. This is where I think AN is in trouble going forward.

The company has proven an ability to sell cars; that is not the problem. The problem is that expectations are way too high and so high, in fact, that I think AN is being set up to fail. When a company posts 7% same store sales growth and shares get hammered, something is wrong with the valuation. This is the main problem I have with AN; the business is terrific but it is still too expensive.

In addition to that, the company's balance sheet is increasingly worrisome to me. This is a company with a $6.4 billion market cap that has $3.6 billion in payables and another $1.8 billion in long-term debt. That is a lot of cash that is needed to run the business and while AN has had no problem fueling its growth in the past, I worry that if sales begin to slow appreciably we could see AN liquidate inventory to meet cash needs. This has not happened yet but if auto sales in general slow down, which they will at some point, AN could be forced to sacrifice margins in order to meet cash needs. I'm not suggesting it will happen but it is something to keep in mind; AN is precariously financed, in my view, and the payables portion is contingent upon the company being able to continue to unload its inventory. If that stops happening at the same rate it is then AN could be stuck with cars it cannot pay for.

Overall I like AN but given the risks in its business, it is far too expensive. The company's business will face a cyclical slowdown at some point and when that happens, I fear the company's aggressive financing will put it in danger. We also cannot expect, like analysts do, that this company will continue to post ~15% earnings growth forever. Even with this growth the company's shares would be overvalued and without it, look out below. I think AN is a buy around $35 to $40 on lower earnings expectations in the future but above that, it's too expensive.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.